The river is never still

 Should the National Bank base policy on old data?

Last week the central bank of Kazakhstan cut the base rate of interest sharply with cool confidence, partly because it thought that this would not cause the exchange rate to go haywire again. The National Bank explained that the tenge was already holding its own in currency markets. “According to [our] estimates,” the National Bank wrote in its press release last Monday, “...the exchange rate of tenge reflects a combination of fundamental external and internal factors that is evidenced by minor changes of the rate over the past months and the level of participation of the National Bank in the domestic foreign exchange market.” Stripped of verbiage, the Bank is saying the exchange rate has stabilized.

Heh. Forty years ago, the Nobel laureate economist Robert Lucas pointed out that when policy changes, so do expectations. A central bank cannot introduce a new monetary policy on the blithe assumption that people will continue to behave as they had before. They won’t.

In particular, a new interest rate will affect how people buy and sell tenge. The old exchange rate will go out the window.

Why? Because forex markets today are fluid. People quickly sell overvalued currencies and buy the undervalued.  This causes the rate of return to fall for the former and to rise for the latter. In equilibrium, every currency should have the same expected rate of return, given the level of risk; otherwise, people will keep buying and selling.

Monday’s cut in Kazakhstani interest rates lowered the rate of return to the tenge. People will dump tenge and grab dollars until they have a new reason to hold the Kazakhstani currency.  And what’s that reason? Anticipated appreciation of the tenge with respect to the dollar.

Since Kazakhstan’s interest fell by two percentage points, traders will expect the tenge to strengthen by the same amount. Yes, people with tenge-denominated assets will collect less in interest in terms of tenge; but they will expect each tenge to buy more of foreign goods than it had before. Since traders profit by acting quickly on their expectations, they will buy tenge while they are still cheap. In principle, the currency will strengthen, reducing the exchange rate from, say, 338.46 tenge per dollar -- which was the exchange rate last Monday -- to 331.65.  In reality, the exchange rate today is 338.52, a slight depreciation.  But the Bank has been known to intervene.  

“But I thought that the Bank was going to let the market set the exchange rate! That it was not going to intervene in the market again!”

Ah, but that was last August. The Bank has gone back to flying on instruments – buying and selling dollars whenever the tenge seems too strong or weak. Take another look at the end of that Bank quote above. NBK net purchases of foreign currencies in March amounted to $1.2 billion. 

As for the tenge -- how weak is too weak? Mum’s the word at the Bank. – Leon Taylor tayloralmaty@gmail.com


Notes

Despite Keynes's contention, the long run is sometimes worth thinking about, so let's think about it. In equilibrium, the actual exchange rate must equal the expected rate, since otherwise trade in currencies will continue.  This means that the interest rate in Kazakhstan must eventually equal the rate offered by trading partners (again, adjusted for risk). So the Bank's attempt to cut the interest rate may be temporary. Which  probably suits the Bank.
    

References

Paul Krugman, Maurice Obstfeld and Marc Melitz. International economics: Theory & policy. Ninth edition. 2012. Includes a good discussion of the interest parity condition – i.e., the idea that exchange rates will adjust in order to ensure the same rate of return to holding either of two currencies.

Robert Lucas. Econometric policy evaluation: A critique. Carnegie-Rochester Conference Series on Public Policy. 1976. Online.