1 1
Latin America’s Road to Inflation Targeting: Lessons and Highlights
Augusto de la Torre and Alain Ize
Central Bank of Rwanda – International Research Conference
Monetary Policy in Developing Countries
Kigali, Rwanda 19 July 2012
Chief Economist Office Latin America and the Caribbean Region The World Bank
Why is LAC’s experience relevant to countries pondering whether to adopt inflation targeting?
Extremely rich and diverse history of trials, failures, and successes Remarkable achievements in strengthening monetary control over the
past two decades
LAC currently at the frontier of inflation targeting Including the incorporation of macro-prudential objectives
Key challenges remain, especially as regards the broadening of objectives/concerns
2
LAC has been a laboratory of monetary policy frameworks
3 Source: Ilzetxki, Reinhart and Rogoff (2011) and LAC Chief Economist calculations.
0
5
10
15
20
25
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Monetary Regimes in LAC Absolute Number of Countries
Dollarized+Hard Peg Soft Peg Monetary Targeters IT
Source: Ilzetxki, Reinhart and Rogoff (2011) and LAC Chief Economist calculations.
1970 1987 1997 2010
Argentina Bahamas, The Bahamas, The Bahamas, TheBahamas, The Barbados Barbados Barbados
Barbados Belize Belize BelizeBelize ECCB ECCB ECCB
Costa Rica Panama Guyana EcuadorECCB Guyana Panama El Salvador
Guatemala Haiti Bolivia HondurasGuyana Jamaica Brazil Panama
Haiti TTO Chile SurinameHonduras Argentina Colombia ArgentinaJamaica Bolivia Costa Rica BoliviaMexico Brazil El Salvador Costa RicaPanama Chile Guatemala Guyana
Suriname Colombia Haiti JamaicaUruguay Costa Rica Honduras Nicaragua
Venezuela Dom. Rep. Jamaica ParaguayBolivia Ecuador Nicaragua TTO
Dom. Rep. El Salvador Paraguay VenezuelaEcuador Guatemala Peru Dom. Rep.
El Salvador Honduras Uruguay GuatemalaNicaragua Mexico Venezuela HaitiParaguay Nicaragua Argentina Uruguay
TTO Paraguay Dom. Rep. BrazilBrazil Peru Ecuador ChileChile Suriname Mexico Colombia
Colombia Uruguay Suriname MexicoPeru Venezuela TTO Peru
IT
Monetary Targeters
Soft Peg
Dollarized+Hard Peg
Outline of this presentation
Domestic follies and world shocks – the roots of perdition
Regaining control – the road to redemption
How well has inflation targeting worked in LAC?
Moving towards and consolidating IT – lessons from LAC
5
The roots of perdition Domestic follies and world shocks
6
LAC’s tumultuous monetary history
The pre-80s monetary and external frameworks … Dollar anchoring with occasional step devaluations An unstable mix of protectionism and open capital accounts
… were shaken by three big inter-related shocks An intellectual shock: ECLAC structuralism – an early manifestation of
supply side economics where money follows cost-pushed inflation A fiscal shock: an expanding (supply-promoting) but unfinanced state
leading to fiscal dominance A world shock: easy credit (oil boom) fueling fiscal expansion, followed
by tight money (Volcker’s stabilization) leading to sovereign debt crises
The outcomes: runway inflations, debasement of currencies, financial meltdowns, dollarization
7
The advent of fiscal dominance in the 1980s
8 Sources: WDI.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1975 1985 1995 2005 2010
Total External Debtover GDP, median of LAC-7+ Uruguay
130%
The loss of a nominal anchor in the 80s and early 90s
9 Notes: LAC6 includes Argentina, Brazil, Chile, Colombia, Mexico and Peru. Inflation is a 5-year rolling, year-on-year rate. Source: IFS
0.50.70.91.11.31.51.71.92.12.32.52.72.93.1
-14-12-10-8-6-4-202468
10
Jan-8
4M
ay-8
5Se
p-86
Jan-8
8M
ay-8
9Se
p-90
Jan-9
2M
ay-9
3Se
p-94
Jan-9
6M
ay-9
7Se
p-98
Jan-0
0M
ay-0
1Se
p-02
Jan-0
4M
ay-0
5Se
p-06
Jan-0
8M
ay-0
9Se
p-10
log I
nfla
tion
Rate
Cum
ulat
ive R
eal I
nter
est R
ate
Real Interest Rate and Inflation Rate
Average Real Interest Rate LAC6 Average Log Inflation LAC6 (rhs)
101%1000%
16%5.47%
Debt Crisis - High Inflation Desinflation Inflation Targetting
10 Note: the Index Rate is the compounded real deposit interest rate applied to 100 base at the beginning of the period (Jan 1978). The plotted variable (in blue) thus reflects the evolution over time of the real value of the initial deposit base. Source: de la Torre, Ize, Schmuckler (2012).
Financial instability and financial intermediation crashes
0
50
100
150
200
250
300
350
400Ja
n-78
Nov
-78
Oct
-79
Sep-
80A
ug-8
1Ju
l-82
Jun-
83M
ay-8
4A
pr-8
5M
ar-8
6Fe
b-87
Jan-
88D
ec-8
8N
ov-8
9O
ct-9
0Se
p-91
Aug
-92
Jul-9
3M
ay-9
4A
pr-9
5M
ar-9
6Fe
b-97
Jan-
98D
ec-9
8N
ov-9
9O
ct-0
0Se
p-01
Aug
-02
Jul-0
3Ju
n-04
May
-05
Apr
-06
Mar
-07
Feb-
08D
ec-0
8N
ov-0
9O
ct-1
0
Real Credit to the Private Sector and Compounded Real Deposit Rate IndexMedian LAC-6
LAC Real Credit Index rate
Debt CrisisHigh Inflation
Crisis Tequila
Asian and Russian Crises
BrazilianStress
GlobalCrisis
Desinflation Inflation TargetingOil
Recycling
Onset of the Debt Crisis
Andean and South Cone Crises
11 Source: Laeven and Valencia (2008), Reinhart and Rogoff (2008) and LAC Chief Economist Office.
Systemic financial crises, especially in the 1990s
2007-2008 1994-1998 1980-1985 2007-2008 1994-1998No. Of Crises-hit CountriesHigh Income 19 6 - 4 2
OECD only 18 4 - 4 1Middle east & N. Africa 0 1 - 0 2South Asia 0 0 0Sub-Saharan Africa 0 9 - 6 31East Asia & Pacific 1 6 - 0 7Europe & Central Asia 3 9 - 3 17Latin America & Caribbea 0 11 8 0 3
Total 13 42 - 13 62
LAC Countries1980-1985 2007-2008 1994-1998
Mexico (94) Argentina (80) Mexico (94)Bolivia (94) Paraguay (95) Brazil (85) Suriname (94)Brazil (94) Uruguay (02) Chile (80) Venezuela (94)Colombia (98) Venezuela (94) Colombia (82)Costa Rica (94) Ecuador (80)Ecuador (98) Mexico (81)Haiti(94) Peru (83)Jamaica (96) Uruguay (81)
Argentina (95)(01)
Currency crises
Systemic Banking Crisis Currency crises
1994-2002Systemic Banking Crisis
Financial dollarization – a common response to runaway inflation that persisted during the disinflation period…
Source: Levy Leyati and IMF data. 12
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Dollarization in Selected LAC countries
Bolivia Paraguay Peru Uruguay
Oil RecyclingDebt Crisis
High Inflation Desinflation Inflation Targeting
… but in Brazil, indexed money was the coping mechanism
13 Note: “Hedge” stands for the Minimum Variance Portfolio (MVP), which equals the covariance of the real exchange rate (or indexed money) with the price level, divided by the variance of the real exchange rate (or indexed money). The safe haven effect equals the covariance between the index (exchange rate or DI) and the industrial production index divided by the variance of the index. Sources: Ize and Levy-Yeyati (2003); LAC Chief Economist Office.
80s 90s 00s(a) (b)
Dollar indexation 0.92 0.89 -0.5
DI indexation 0.89 0.96 0.19
Dollar indexation -0.25 -0.38 -0.09
DI indexation -0.25 -0.57 -0.01
Normalized covariance between (a) and (b)
Hedge
Safe Haven
Brazil Optimal Hedges: DI indexation versus Dollar indexationNormalized covariance by decade
The road to redemption Regaining control
14
A gradual shift towards full-fledge inflation targeting
Clear benefits to announcing explicit inflation targets Directly anchors inflation expectations
• Facilitates coordination – wage and price setting, fiscal budgeting, etc. • Helps develop longer-term financial instruments
Promotes transparency and accountability Allows for a good mix of rules (commitment) and discretion (depending
on shocks) ⇒ Reduces sacrifice ratios (the output cost of inflation stabilization)
But effective commitment to an inflation target hinges on how implemented, which depends on macro-financial conditions
15
Putting the inflation genie back into the bottle Three stages of inflation targeting
Stage I Stage II Stage III
Final target Inflation Inflation Inflation
Operational target Exchange rate Bank reserves Interest rate
Primary shock absorber
International reserves Interest rate Exchange rate
Secondary shock absorber Interest rate Exchange rate International
reserves
Towards full-fledge inflation targeting
16
The rocky road towards inflation targeting in LAC
Source: Ilzetxki, Reinhart and Rogoff (2011) and LAC Chief Economist Office calculations.
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Monetary Regimes in LAC Weighted by 2010 GDP Shares
IT Monetary Targeters Soft Peg Dollarized+Hard Peg
Oil RecyclingDebt Crisis
High Inflation Desinflation Inflation Targeting
Stage 1: exchange rate-based disinflation
Benefits Where inflation is very high and unstable, the exchange rate becomes
the only remaining credible, visible anchor A pre-determined nominal exchange rate path limits financial stress in
dollarized systems Simple to implement, even in the absence of money and bond markets,
as money demand endogenously determines money supply
Limitations Risk of consumption/credit booms and exchange rate overvaluations
leading to twin crises (MX 1995, ECU 1999, ARG 2001, URU 2002) Promotes e-rate passthrough, wage indexation, and dollarization
• This exacerbates inflationary inertia and fear of floating The loss of monetary policy independence is plainly inadequate for the
larger, more closed economies 18
Stage 2: money-based inflation stabilization
Benefits Controlling a monetary aggregate (e.g., bank reserves) is a way to recover
monetary policy independence The interest rate as the primary shock absorber helps limit exchange rate
volatility and thus (under a high passthrough) inflation volatility Can function even under relatively thin money and bond markets
Limitations Sluggish transmission, less transparent signaling and communication Complications that arise from unstable money demand
• “We did not abandon monetary aggregates, they abandoned us” (John Crow) • Targeting bank reserves during re-monetization episodes introduces a
contractionary bias (through a high i-rate and an appreciated e-rate)
Fear of floating remains, limiting the easing of passthrough & dollarization Short-term interest rate volatility hinders financial development
19
Stage 3: full-fledge inflation targeting
Benefits Provides the most transparent (hence effective) monetary signal Enhances monetary policy transmission Promotes de-dollarization Facilitates financial deepening (yield curve)
Limitations May not be appropriate for high inflation countries or countries that
lack a sufficiently developed money market Comes under stress in times of high capital inflows and/or supply
shocks
20
How well has IT worked in LAC?
21
The full-fledge inflation targeters have outperformed the rest in keeping inflation low and stable…
22 Notes: To plot this variable, we use country groupings consistent with the monetary regime that was in effect in 2010. Source: GEM.
-5
0
5
10
15
20
Jan-
04
May
-04
Sep-
04
Jan-
05
May
-05
Sep-
05
Jan-
06
May
-06
Sep-
06
Jan-
07
May
-07
Sep-
07
Jan-
08
May
-08
Sep-
08
Jan-
09
May
-09
Sep-
09
Jan-
10
May
-10
Sep-
10
Jan-
11
May
-11
Sep-
11
Jan-
12
May
-12
Inflation RateYoY seasonally adjusted, median of each group
Dollarized+Hard Peg Soft Peg Monetary Targeters IT
… in stabilizing inflation expectations, despite the shocks …
23 Notes: PPP-GDP weighted average for Brazil, Chile, Colombia, Mexico and Peru. Sources: Consensus Economics, Consensus Forecast, Haver Analytics, IMF
… in significantly reducing the passthrough …
Source: Pinto Nogueira (2007) 24
Short-run Long-run Short-run Long-run Short-run Long-run
Brazil 0.451* 1.295 0.081* 0.599*(0.166) (0.360) (0.021) (0.320)
Mexico 0.076* 1.0138* 0.154* 0.261*(0.009) (0.065) (0.022) (0.103)
-0.696*
0.078* -0.758*
Before Inflation Targeting After Inflation Targeting Change in pass-Though
-0.370*
Pass-through estimates PPI inflation
… in altering wage formation …
0.00
0.02
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
95-96 96-97 97-98 98-99 99-00 00-01 01-02
Brazil
95% Confidence Bands ( r) CPI InflationMinimum Wage Growth Focal point of DRWR ( r )
Introduction of Inflation Targeting
Source: Messina and Sanz-de-Galdeano (2011)
… in promoting financial deepening …
26 Notes: Graphs represent the remaining maturities in years. For Brazil, swap rates long-term government bonds (NTN-F) are plotted; for Colombia, zero coupon yield curves; for Mexico, Cetes and government bonds; and for Peru, government bonds of the secondary market. Source: National data and BIS
… and in providing a countercyclical capacity
Notes: We used for the left panel the interest rate of the money market as reported for Brazil, Colombia, Mexico and Peru. For Brazil, the selected crisis is October 1997; for Chile and Colombia, April 1998; for Mexico, February 1995; and for Peru, August 1998. Source: IFS and Bloomberg
0
50
100
150
200
250
-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10
Inde
x cr
isis
=10
0
crisis in month=0
Monetary Policy RatePrevious crisis in the 90s
Brazil Chile Colombia Mexico Peru
0
20
40
60
80
100
120
01/2
5/08
02/1
5/08
03/0
7/08
03/2
8/08
04/1
8/08
05/0
9/08
05/3
0/08
06/2
0/08
07/1
1/08
08/0
1/08
08/2
2/08
09/1
2/08
10/0
3/08
10/2
4/08
11/1
4/08
12/0
5/08
12/2
6/08
01/1
6/09
02/0
6/09
02/2
7/09
03/2
0/09
04/1
0/09
05/0
1/09
Inde
x Se
pt-0
8=10
0
Monetary Policy RateGlobal crisis
Brazil Chile Colombia Mexico Peru
But, has full-fledge IT promoted real appreciation?
28 Source: IFS
The real appreciation trend was stronger for full-fledge inflation targeters until the Lehman collapse…
29 Notes: To plot this variable, we use country groupings consistent with the monetary regime that was in effect in 2010. Sources: IFS.
60
70
80
90
100
110
120
130Ja
n-02
Jun-
02N
ov-0
2A
pr-0
3Se
p-03
Feb-
04Ju
l-04
Dec
-04
May
-05
Oct
-05
Mar
-06
Aug
-06
Jan-
07Ju
n-07
Nov
-07
Apr
-08
Sep-
08Fe
b-09
Jul-0
9D
ec-0
9M
ay-1
0O
ct-1
0M
ar-1
1A
ug-1
1Ja
n-12
Real Effective Exchange RateJan2002=100, vis-à-vis the US dollar
Dollarized+Hard Peg Soft Peg Monetary Targeters IT
… despite intense intervention …
30 Notes: To plot this variable, we use the country grouping that results from the monetary regime in effect in 2010. Sources: IFS and WDI.
0
50
100
150
200
250
300
350
400
450
500Ja
n-05
Apr
-05
Jul-0
5O
ct-0
5Ja
n-06
Apr
-06
Jul-0
6O
ct-0
6Ja
n-07
Apr
-07
Jul-0
7O
ct-0
7Ja
n-08
Apr
-08
Jul-0
8O
ct-0
8Ja
n-09
Apr
-09
Jul-0
9O
ct-0
9Ja
n-10
Apr
-10
Jul-1
0O
ct-1
0Ja
n-11
Apr
-11
Jul-1
1O
ct-1
1Ja
n-12
International Reserves2010 GDP-PPP weighted average of each group, base 2005=100
Dollarized+Hard Peg Soft Peg Monetary Targeters IT
… and partly due to high real interest rates
31 Notes: To plot this variable, we use country groupings consistent with the monetary regime that was in effect in 2010. For Chile, the money market rate has been deflated by wholesales prices. Source: IFS.
0
5
10
15
20
25Ja
n-03
Jun-
03N
ov-0
3A
pr-0
4Se
p-04
Feb-
05Ju
l-05
Dec
-05
May
-06
Oct
-06
Mar
-07
Aug
-07
Jan-
08Ju
n-08
Nov
-08
Apr
-09
Sep-
09Fe
b-10
Jul-1
0D
ec-1
0M
ay-1
1O
ct-1
1
Real Interest RateMoney Market Rate deflated by CPI, median of each group, in %
Dollarized + Hard Peg Soft Peg Monetary Targeters IT
But full-fledge IT has provided a significantly greater shock absorption capacity via the nominal exchange rate…
32 Notes: To plot this variable, we use country groupings consistent with the monetary regime that was in effect in 2010. Sources: IFS and WDI.
60
70
80
90
100
110
120
130
Jan-
03
Jun-
03
Nov
-03
Apr
-04
Sep-
04
Feb-
05
Jul-0
5
Dec
-05
May
-06
Oct
-06
Mar
-07
Aug
-07
Jan-
08
Jun-
08
Nov
-08
Apr
-09
Sep-
09
Feb -
10
Jul-1
0
Dec
-10
May
-11
Oct
-11
Mar
-12
Nominal Exchange RateJan2003=100, vis-à-vis the US dollar
Dollarized+Hard Peg Soft Peg Monetary Targeters IT
… in sharp contrast with the pre-IT era
Sources: World Bank Indicators and Bloomberg.
80
90
100
110
120
130
140
Apr-97 May-97 Jun-97 Jul-97 Aug-97 Sep-97 Oct-97
Inde
x Ju
l-97=
100
Nominal Exchange Rateprevious crisis
Brazil Chile Colombia Mexico Peru
80
90
100
110
120
130
140
Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09
Inde
x Se
pt-0
8=10
0
Nominal Exchange RateGlobal crisis
Brazil Chile Colombia Mexico Peru
Lessons from LAC Moving towards and consolidating IT
34
Pre-conditions for launching single objective IT
Inflation cannot be too high
Fiscal dominance must have ceased
Central banks must have minimum independence and capability (statistics, analysis, communication, etc.) Basic systems to conduct open-market operations
Foreign currency, interbank, and money/repo markets must have a minimum depth
Countries must be large enough to have their own currency
⇒ The time may not be the right one ⇒ IT may not be the right regime 35
Looking forward, a gradual shift towards multiple objectives is unavoidable yet challenging
Output stability With supply shocks (where there is no “divine coincidence”), some short-
term output targeting is unavoidable As credibility improves, output stabilization can acquire a larger weight
Exchange rate competitiveness Most IT countries care about the exchange rate and many intervene But how to pursue it without clashing with the impossible trinity?
Financial stability The global financial crisis has shown that monetary policy must be more
concerned about financial stability But where to draw the line and ensure complementarity between
monetary and macro-prudential policies?
36
37
Thank you
