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News : Global Economy Last Updated: Sep 15, 2011 - 7:13 AM

IMF says amidst high global food and fuel prices central banks should provide clarity on inflation targeting
By Finfacts Team
Sep 15, 2011 - 5:47 AM

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The IMF (International Monetary Fund) on Wednesday warned that amidst high global food and fuel prices, central banks need to clearly identify and communicate their inflation targets or risk undermining their credibility in the markets.

The Fund on Wednesday released Chapters 3 and 4 of the World Economic Outlook, which includes the latest forecasts, will be released next week - - on Tuesday, September 20th - - just ahead of the annual meetings.

John Simon, senior economist, IMF Research Department, told a press briefing in Washington DC that central banks should focus on the medium-run element of inflation -- the element that is not affected by short-run commodity price volatility. So that boils down to targeting underlying inflation. He said what the economists find is that these effects vary, depending on the nature of the country. And, in particular, there seems to be a separation between advanced countries, which tend to have highly credible central banks and relatively low shares of food in the consumption basket, and emerging and developing economies, where there is less credibility of the central bank, and generally higher shares of food in the consumption basket.

And what the effect of these means is that in these emerging and developing countries, food price shocks can have a much larger effect on headline inflation. And so the challenges that these banks face are much higher.

The IMF reiterated calls for accommodative monetary policy in advanced economies and more aggressive action in some emerging markets.

Chapter 4 deals with fiscal policy and it says fiscal tightening will be one of the key factors shaping the global economy over the coming years. The economists said there are many advanced economies which are tightening substantially to strengthen fiscal sustainability, and also many emerging and developing economies which are tightening both to rebuild fiscal policy room and, in some cases, to restrain overheating pressures.

So, one natural question to ask is, what effect would these fiscal adjustments have on countries’ external balances?

Over a period of 30 years, the Fund found that fiscal policy has a large and long-lasting effect on the current account. A one-percent-of-GDP fiscal cut typically improves the current account by just over half a percent of GDP within the first two years. And this improvement in the current account persists over the medium term.

The improvement in the current account takes place not just because imports fall as a result of lower consumption and investment. The economists also found that exports rise, because the currency tends to weaken following a fiscal tightening.

In countries where the exchange rate is fixed, or where monetary policy is limited or constrained, "the good news is that one actually sees just as much of a current account improvement -- just as much of a current account response to fiscal policy."

The bad news is that it occurs in a more painful manner. "And what we mean by that is that you tend to see a bigger decline in economic activity, because monetary stimulus can’t offset the negative effects of the fiscal tightening. In addition, the real exchange-rate depreciation takes place via a compression of domestic wages and prices, a process that’s sometimes referred to as 'internal devaluation.'"

This is the situation in the Eurozone.

There is one special case where fiscal policy has very small effects on the current account, and that’s when all countries are tightening by exactly the same amount. In that case, countries are buying less from the rest of the world, but the rest of the world is buying less from each country as well, and the net effect is lower global demand but not much change in current accounts.

The economists said that’s not the case we’re in at present. "What we have now is many countries tightening, but some countries are tightening fiscal policy by a substantial amount, and other countries are tightening by much less. And in this case, what matters is how much tightening a country is doing relative to the others.

Germany, for example, is consolidating, but it’s doing so by less than the other Eurozone economies. And as a result, these fiscal adjustments within the euro area will actually help reduce imbalances within the Eurozone.

Similarly, emerging Asia is also planning to consolidate, but it’s going to do so by less than the rest of the world. As a result, that will help bring down that region’s large trade surplus.

And finally, in the United States, much of the tightening that’s in the pipeline is actually exit from stimulus, rather than more permanent measures, such as entitlement reform, that have the biggest impact on the current account. And this relative lack of permanent fiscal measures, alongside the fact that everybody else is also consolidating substantially, means the current US fiscal plans will probably not contribute to reducing the US current account deficit."

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