Inflation targeting is widely regarded as the best approach to monetary policy, including for small, open economies.
Pioneered by New Zealand and Canada in the early 1990s — and quickly adopted by Australia, Sweden and the UK, and then Iceland and Norway, among others — it is credited with having dramatically lowered the level and variability of inflation wherever it has been consistently applied. Lower and predictable inflation has, in turn, proved conducive to better economic performance, helping to prevent the large shifts in income distribution that can follow from unexpected inflationary surges (at least until the Covid-19 pandemic struck).
It is not difficult to see why inflation targeting has had this effect. The approach forces the central bank to focus squarely on price stability in ways that earlier policy strategies did not. It thus offers transparency with respect to monetary-policy goals and the measures needed to achieve them, and these signals build public confidence.
And yet, the standard narrative about inflation targeting rests on a false assumption. In fact, many of the economies that apply this approach are not all that open. World Bank data show that the trade-to-GDP ratio is only about 50% in Australia and New Zealand, 70% in Canada and the UK, and 90% in Scandinavia. That is a far cry from the 384% ratio in Hong Kong, 336% in Singapore, 140% in Switzerland, and 128% in Denmark — all economies that do not employ inflation targeting.
Given the latter cohort’s strong performance, it would seem that inflation targeting is not right for extremely open economies. That is why economies in the EU with a trade-to-GDP ratio of over 300%, including Luxembourg and Malta, have banded together with others to use the euro. It is also why Denmark, which is adjacent to the much larger eurozone economy, has tied its exchange rate to the single currency.
Hong Kong, too, has fixed its exchange rate, though largely for reasons that are unlikely to apply to other economies. Its currency board was introduced in 1983, when the Hong Kong dollar experienced a catastrophic depreciation following China’s declaration that it would resume sovereignty over the region in 1997. These kinds of political developments can have large exchange-rate effects that are unwarranted on macroeconomic grounds. By fixing its exchange rate, Hong Kong could insulate its economy from such shocks.
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Considering that the Hong Kong economy is adjacent to the huge economy of mainland China, it would be natural for it to fix its currency to the renminbi — as was the case until 1935, when both currencies were on the silver standard. But since the mid-1970s, Hong Kong has fixed its exchange rate to the US dollar, because one cannot peg to a currency — like the renminbi — that is not fully convertible, and for which there is no deep and liquid market.
Switzerland and Singapore have chosen another route. Their economies are too exposed to exchange-rate movements for traditional inflation targeting to be feasible, so they have adopted monetary-policy strategies tailored to their own specific circumstances — strategies that share several characteristics.
For starters, both Switzerland and Singapore maintain a clear focus on price stability. While the Swiss National Bank (SNB) has defined this as inflation of less than 2%, the Monetary Authority of Singapore (MAS) has been able to leave it undefined, thanks to a long and successful track record that effectively speaks for itself.
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Second, both have a clear view about what exchange-rate level is appropriate, and both steer the exchange rate toward that range. Since the SNB also sets interest rates, it has occasionally used that mechanism to influence the exchange rate (sometimes with massive interventions). The MAS does not set interest rates, so it has established an exchange-rate band.
Third, neither central bank publicly announces the exact exchange-rate level that it considers appropriate. While central banks can set the interest rate at which they lend to, or accept funds from, the banking system, the exchange rate is determined by the market. Were they to disclose a specific exchange-rate objective, market participants would have an open invitation to speculate against the central bank, which could complicate monetary-policy management.
Finally, both strategies recognise the benefit of being able to adjust the exchange rate as economic conditions evolve (a permanently fixed exchange rate is unlikely to be optimal). The result of these strategies is enviable records of inflation control. The average inflation rate in 2000-2023 is 0.6% in Switzerland and 2% in Singapore (exactly equal to the 2% for which inflation-targeting central banks generally aim).
Both economies owe their strong performance to the fact that monetary authorities have allowed their exchange rates to undergo large movements when necessary. Bank of International Settlements data show that the effective nominal exchange rate — best thought of as the average exchange rate against all trading partners — strengthened in this period by an average of 1.3% per year in the case of Singapore, and by 2.6% in the case of Switzerland, thereby lowering the cost of imports and dampening inflation.
It is not easy to stand out from the crowd in policymaking. But Singapore and Switzerland have forged their own paths, with great success. While inflation targeting is a good strategy for many economies, extremely open economies would do well to consider the alternatives. — © Project Syndicate, 2024
Stefan Gerlach, chief economist of EFG Bank in Zurich, is a former executive director of the Hong Kong Monetary Authority and a former deputy governor of the Central Bank of Ireland
