The Path to Predictability: Resolving Inflation and Exchange Rate Puzzles in EMEs

This study finds that incorporating forward-looking expectations into monetary models resolves the "price" and "FX" puzzles in emerging markets, where policy tightening paradoxically raises inflation and depreciates the currency. By including expectations, models more accurately predict how interest rate changes affect inflation and exchange rates.

The working paper "Resolving Puzzles of Monetary Policy Transmission in Emerging Markets," developed by researchers Jongrim Ha, Dohan Kim, M. Ayhan Kose, and Eswar S. Prasad from the World Bank and Cornell University, examines two long-standing issues in monetary policy for emerging market economies (EMEs): the “price puzzle” and the “FX puzzle.” These puzzles describe counterintuitive responses of inflation and exchange rates to monetary policy tightening where policy tightening (raising interest rates) unexpectedly raises inflation and causes the currency to depreciate. Using a structural vector autoregressive (SVAR) model, the authors find that the puzzles persist in many EMEs, indicating that traditional economic models fail to account for the unique monetary dynamics in these markets. However, when these models are adjusted to include forward-looking expectations, particularly inflation and exchange rate forecasts from professional, business, and consumer surveys, the puzzles are mitigated. The study provides a comprehensive framework, testing these modifications across numerous EMEs and highlighting the role of expectations in addressing the complexities of monetary policy impacts.

Testing the Basics of Monetary Policy Models

The authors first establish the presence of these puzzles in EMEs using a baseline SVAR model, which includes control variables such as commodity prices and global demand shocks, to assess how policy rate changes impact inflation and exchange rates. The price puzzle, often observed in empirical studies, suggests that monetary tightening can lead to higher, rather than lower, prices. This pattern contrasts with standard economic theory, which holds that raising interest rates should curb inflation by dampening demand. In their analysis, the authors show that in a majority of EMEs, this puzzling price increase can be attributed to currency depreciation, as a weaker currency drives up import costs and contributes to inflation. This connection suggests that resolving the FX puzzle could, in turn, help address the price puzzle, providing an interconnected solution to both phenomena. The study tests multiple variations of the SVAR model, including recursive ordering of variables, factor-augmented SVAR models that account for global variables, and high-frequency identification with daily data. None of these modifications successfully eliminate the puzzles. Only when survey-based expectations of inflation, output, interest rates, and exchange rates are incorporated does the model align with theoretical predictions, showing that inflation falls and currency appreciates after monetary tightening.

The Power of Expectations in Shaping Outcomes

Expectations data play a crucial role in this approach, as they capture insights about future inflation developments that are otherwise missed in traditional models. The authors hypothesize that central banks in EMEs possess additional information, possibly related to adverse supply shocks, that informs their decisions but is not reflected in SVAR models. By excluding expectations, these models effectively “omit” a significant predictor of inflation and exchange rate behavior, leading to a misrepresentation of policy impacts. Incorporating expectations resolves these issues by offering a more accurate representation of central banks’ decision-making process and its impact on financial variables, thus resolving both puzzles. For instance, a 1% contractionary monetary policy shock in the expectation-adjusted model results in a 0.9% decline in output, a 0.3% decrease in prices, a 0.6% currency appreciation, and a 2% drop in stock prices, a set of results consistent with conventional monetary theory.

Testing Expectations-Driven Models Across Economies

To validate these findings, the authors apply the model in various configurations and use external instruments to identify monetary policy shocks based on expectations data. By regressing policy rates on market forecasts of inflation and output, they isolate the systemic component of monetary policy, treating the residual as the “shock” in the SVAR model. This approach shows that expectations resolve the puzzles more effectively than other models, especially for inflation responses, which turn negative within a year of a monetary tightening, aligning with theoretical predictions. Exchange rate responses also shift, showing appreciation rather than depreciation after monetary tightening. The research highlights that these puzzles likely stem from omitted supply-side shocks that influence inflation expectations and monetary transmission, underscoring the role of expectations in accurately predicting outcomes. The analysis also explores the unique impact of different types of expectations consumer, business, and professional, and finds that inflation expectations are the most influential in predicting price and currency responses.

Interconnected Puzzles and the Role of Exchange Rates

The connection between the price and FX puzzles suggests a shared mechanism: once the FX puzzle is resolved through appreciation rather than depreciation, inflationary pressures subside, resolving the price puzzle. The findings imply that exchange rates function as a primary transmission channel for monetary policy in EMEs. As currency depreciation exacerbates inflation through import costs, controlling exchange rate responses becomes essential to achieving stable inflation outcomes. The authors note that even in advanced economies, central banks benefit from incorporating expectations into their models, and in EMEs, the need for such adjustments is even greater due to higher economic volatility and more pronounced currency impacts on inflation.

A New Path for Monetary Policy in Emerging Markets

The study underscores the importance of modeling forward-looking expectations in EMEs to achieve effective monetary policy. Incorporating survey-based expectations into SVAR models captures key insights that central banks use in their decision-making, providing a better forecast of inflation, currency, and financial responses. The research suggests that central banks in EMEs should enhance data on inflation expectations to refine their monetary policy responses, as expectation-driven approaches could be key to stabilizing inflation and financial conditions in these markets. This expectation-based approach resolves the anomalies in monetary transmission, reinforcing the need for EMEs to adopt forward-looking methods for effective economic policy.