Financial Stability Implications of Policy Mix in a Small Open Commodity-Exporting Economy

In this paper, we study how systematic monetary policy under inflation targeting in a commodity-exporting economy not fully isolated from commodity price volatility by fiscal policy may contribute to financial instability by fueling the credit cycle when commodity prices increase or by amplifying the credit crunch when commodity prices decline. We report several empirical observations that illustrate the potential procyclicality (relative to credit developments) of inflation targeting policy where commodity price fluctuations are the main drivers of macroeconomic developments. Namely, we find that relative prices in commodity-exporting economies are much more volatile than in other countries. The length of periods when relative prices grow or decline is comparable to the monetary policy horizon of most inflation targeters (2-3 years). Note that the central banks that target inflation, including those of the commodity-exporting countries, usually target the headline CPI. This index accommodates relative price changes by design. We proceed with formal statistical testing using panel structural VARs and local projection models. The tests support the procyclicality of inflation targeting, but only in a group of emerging market economies, which in practice have more procyclical fiscal policy than advanced economies: monetary policy eases in response to a higher price of an exported commodity while real credit grows. Counterfactual exercises show that endogenous monetary policy responses to commodity shocks explain around 20% on average of the real credit growth in a group of commodity exporting countries for which the reaction of policy rates to commodity shocks is statistically significant. We cross-check the empirical findings by reviewing a collection of papers with estimated DSGE models and analysing impulse responses of real policy rates to commodity price changes. We also conduct a theoretical analysis and compare stabilization properties (while accounting for financial stability risks) of the inflation-targeting policy rule and the ‘leaning against the wind’ policy rules. Notably, we do this exercise conditionally on the role of commodity price shocks for the economy. For this purpose, we use the DSGE with financial frictions and a banking sector estimated basing for the Russian economy and measure the efficiency of policy results with different sensitivity to credit developments (the ‘leaning against the wind’ rules) under different variance of oil price shocks (which may be interpreted also as different efficiency of fiscal policy in insulating the economy from a given oil price volatility). Results show that when commodity price volatility is relatively high (fiscal policy is not countercyclical), leaning against the wind outperforms pure inflation targeting, thus supporting our empirical findings. Interestingly, even when the financial stability risks associated with the volatility of credit developments are negligible, a moderate leaning against the wind policy is still preferable. As policy implication, we point that a commodity-exporting economy should have countercyclical fiscal policy for inflation targeting to become countercyclical in a commodity cycle.