Currency hierarchy, Financialization and Inflation Targeting

Financialization & Monetary Policy Dilemmas in EME: the case of Brazil

One of the main implications of financialization on emerging market economies (EMEs) are the changes in the volume and pattern of capital flows. With the increasing importance of institutional investors, their increasingly short-term focused practices, and the rise of instruments that facilitate these, as derivatives, EMEs’ assets and currencies have become highly demanded options for speculation.

The consequences for these countries include volatile exchange rates especially due to frequent extreme depreciations, and their closer association with international financial conditions and with other EMEs’ currencies.

This dynamic is however stronger in a few EMEs. Why do institutional investors choose these countries and not others? Apart from options associated with deep and sophisticated financial markets, high interest rates are certainly important attractors.

Studying this question, the paper analyses how a combination of high exchange rate pass through to inflation with a rigid inflation targeting regime might have an impact on the interest rate level and set out a self-reinforcing situation of high interest rates and volatile exchange rates.

Through these mechanisms, the developments of financialization in central economies would be creating an external constraint in EMEs that prevents monetary policies from focusing on domestic issues.

Keywords: Financialization; Emerging Market Economies; Exchange Rates; Inflation Targeting