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The Historical Evolution of Monetary Policy in Latin America

  • Esteban Pérez CaldenteyEmail author
  • Matías Vernengo
Living reference work entry

Abstract

Recent monetary policy in Latin America has evolved in five different phases. The first one revolves around the monetary doctoring missions, mainly but not exclusively, from the United States that established the first central banks in the region in the 1920s and 1930s adhering to a gold standard regime. The second phase comprises the first attempts to adopt a proactive countercyclical monetary stance and the granting of ample discretionary powers to the central bank to protect economies from the effects of the international business cycle. The third phase consists in the generalized adoption of developmental and inward industrialization goals by central banks. The fourth phase is characterized by central bank’s abandonment of developmental objectives placing the focus of their actions on price stability. The last phase in the evolution of monetary policy centers on inflation targeting. Currently, the most important and pressing challenges of monetary policy relate to its impact and pass-through on the real economy and to the relationships between monetary policy, fiscal policy, the financial system, and financial stability.

Keywords

Gold standard Countercyclical policy Exchange controls Monetary approach to the balance of payments Inflation targeting 

Introduction

Monetary policy in Latin America has evolved in five different phases. The first one revolves around the adoption of the gold standard during the first globalization period at the end of nineteenth century. During the colonial period, the monetary system was tied to the metropolis, and the monetary system was underdeveloped. Metallic currency was scarce, and no colonial banks existed. The first banking experiment in Latin America was associated to the Bourbonic reforms of Carlos III, the so-called Banco de Avío y Minas, created to fund mining activities. The first bank in Brazil was the Banco do Brasil, founded in 1808 with the arrival of the Portuguese royal family to Rio de Janeiro. In Argentina the Banco de la Provincia de Buenos Aires, founded in 1822, is often cited as the first bank. In Mexico the first bank was the Banco de Avío Industrial created by Lucas Alamán in 1830. Banking activities remained limited in the region during the nineteenth century (Marichal and Gambi 2017).

Toward its end, the period is marked by the monetary doctoring missions, mainly but not exclusively from the United States and the United Kingdom, that established the first central banks in the region in the 1920s and 1930s. Monetary policy followed the pro-cyclical rules of the gold standard. Monetary stability, viewed as essential to attract foreign investment, also involved trade measures and fiscal reforms to balance the budget. The gains from the reforms were for the most part temporary and countries experienced increased macroeconomic disequilibria and rising debt. The gold standard experience in Latin American came to an end with the Great Depression, which set the stage for the second phase in monetary policy.

This phase comprises the first attempts to adopt a proactive and, more precisely, countercyclical monetary stance and the granting of ample discretionary powers to the central bank to protect economies from the effects of the international business cycle. The countercyclical aspect of monetary policy marks the beginning of modern central banking in Latin America. During this phase, some central banks also pursued developmental objectives. The instruments used to achieve these objectives included rediscounting, exchange controls, subsidies, and the allocation of credit.

The third phase consists in the generalized adoption of developmental and inward industrialization goals by central banks which, in some instances, prevailed over short-run price stability objectives. The two main instruments used included capital controls and reserve requirements. Capital controls included differentiated and multiple exchange rates for foreign current and capital exchange transactions, between public and private sector, and also between residents and nonresidents. Reserve requirements were used to direct credit to specific economic activities and finance government operations.

During this phase Latin America registered in the 1960s and 1970s the highest average growth on record. At the same time, the rise in inflation in most economies became a growing concern for the monetary authorities. The third phase ends with the 1980s Debt Crisis, which led to a radical shift in economic and monetary policy under the implementation of Washington Consensus policies consisting in liberalization, stabilization, and privatization.

The fourth phase is characterized by central bank’s abandonment of developmental objectives placing the focus of their actions on price stability. Stabilization policies were guided by the monetary approach to the balance of payments (MABP) which views both inflation and the balance of payments position as monetary phenomena. While the MABP recommends focusing on credit rather than money growth relative to output to control prices, countries still adhered to monetary targets and exchange rate management. Countries also introduced changes to central bank legislation addressing the need for political and operational independence and greater transparency and accountability. During this phase, as part of a worldwide trend since the middle of the 1990s, most Latin American countries saw a significant reduction in their inflation rates bringing these to one-digit levels. Monetary policy had to confront financial and banking crises, which drove home the message that price stability cannot be equated with financial stability. As well, the weight placed (at least in some economies) on exchange rates management created a potential conflict with the objective of price stability.

The last phase in the evolution of monetary policy centers on inflation targeting, which since the 2000s has become the most prevalent monetary framework in Latin America. Monetary policy operates through the public announcement of numerical targets for the inflation rate to guarantee transparency and accountability and the countercyclical management of the short-term policy interest rate according to a monetary rule, often associated to some variation of the Taylor rule. The recommendation is to adjust the monetary policy rate in a flexible manner to avoid output and employment costs. In an open economy, inflation targeting is compatible with a freely floating exchange rate that acts as an absorber and dampener of external shocks. The available evidence for Latin America shows that inflation targeting countries do not necessarily pursue a countercyclical monetary policy and that these often intervene in the foreign exchange market in order to control inflation.

Currently Latin America economies have been able, with a few exceptions, to maintain single-digit inflation rates, so that high inflation and its disruptive effects on the real economy are not an impending threat. The most important and pressing challenges for monetary policy relate to its impact and pass-through on the real economy and to the relationships between monetary policy, the financial system, and financial stability.

Antecedents to Central Banking and Monetary Policy

The first initiatives to create central banks in Latin America date back to the nineteenth century as governments, either at the national, regional, or provincial level, took on the power of issuing domestic currency and credit (an activity confined until then to the private sector) for developmental purposes and, also, to finance government operations. National banks were established in several Latin American countries including in Argentina (1826, 1836, and 1891), Bolivia (1911), Colombia (1880 and 1905–1909), Ecuador (1890), and Peru (1821) (Posso Ordoñez 2016; Marichal 2008).

Argentina established the Banco Nacional (1826) to provide credit to the government and reduce its dependency on external inflows. This was followed by the creation of the Casa de la Moneda (1836) to fund public sector deficits and the Banco de la Nación (1891) to stabilize the country’s financial system after the start of the Baring Crisis and promote the agro-export development model. Bolivia created the Banco de la Nación Boliviana (1911). Brazil created the Banco do Brasil in 1808, as noted before, which continued to function for a while after independence in 1822 but was eventually liquidated. The new Banco do Brasil was created in 1853, with the merging of two banks, and given the monopoly on emission. Colombia created the National Bank (1880) to foster the development of the country and authorized to issue currency, receive deposits, and carry out discount operations. Later on, the Central Bank of Colombia operated from 1905 to 1909. Ecuador planned unsuccessfully for the creation of its central bank in 1890. Peru created the Banco Auxiliar de Emision (1821) to issue currency and grant credit. Chile opted for having the Treasury take the role of the central bank.

These initiatives were generally short-lived as these resulted in currency depreciation and inflation (which were in some cases brought about to benefit debtors’ and exporters’ interests) and, in general, monetary disorder and inconvertibility. These initiatives were replaced by exchange offices. One of the most illustrative and well-documented examples is the Argentine Currency Board established in 1899, following a period of monetary instability reflected in the sharp rise and fall of the gold premium due in part to the Baring Crisis (1890–1897).

The exchange office functioned like a currency board. It maintained fixed convertibility of the peso to gold, and through the establishment of a conversion fund, guaranteed that any addition to the money supply should have a 100% gold backing. Similarly, any withdrawal of gold would translate into the withdrawal of an equal amount of paper pesos. Foreign exchange intervention was also allowed to maintain the peso-gold parity. The Currency Board functioned smoothly between its entry into force in 1900 and 1912–1913, helped by fair weather conditions and favorable terms of trade for Argentina.

Contrarily in 1914, the Currency Board faced poor climatic conditions with devastating effects on agricultural production and exports, the balance of trade position, and a depressing impact on land values and capital flows. These effects were reinforced by the needs to finance the European war efforts, which dried up Argentina’s external sources of finance. The resulting contraction of liquidity led to pro-cyclical response with negative effect on income and employment and asset prices (land values). It also aggravated the financial situation of the farmers affected by the weather shock, thus impinging on the recuperation of exports and land values. This provided a further blow to the confidence of foreign investors.

The Creation of Central Banks

The failure of national banks and exchange offices to provide monetary and financial stability, along with a growing international consensus on the need of countries to have a central monetary authority and a gold standard regime, led to the establishment of central banks in Latin America. The first central banks were established in the 1920s by US foreign missions to Colombia (1923), Chile (1925), Ecuador (1927), Bolivia (1928), and Peru (1931). The missions were headed by Edwin Kemmerer (1875–1945), a Princeton University professor and one of the leading developers of the quantity theory of money. Kemmerer was also a financial advisor to the Commission of Administrative Financial Reorganizing as well as to the governments of Mexico (1917) and Guatemala (1919, 1924).

The significance of these missions is explained by the US outward economic and commercial expansion and also by its growing importance as an international creditor. Between 1913 and 1929, US investments in South America increased from US$ 72 to more than US$ 900 million which was above the level reached by British investments. As explained by Kemmerer (1927, p. 4): “It is the desire on the part of the foreign governments through setting their financial houses in order, and through making a favorable impression upon American bankers and investors, to facilitate the borrowing of money by the government in the American market and to encourage the flow of American capital to their shores for private enterprises.” Kemmerer also believed that foreign investment directed trade flows (Kemmerer 1916).

The Kemmerer missions sought to maintain monetary and financial stability through the adherence to the gold standard. Kemmerer was a staunch supporter of the gold standard. Earlier on in his career, he had proposed a Pan-American monetary unit based on the dollar, which was tied to gold, and throughout his career, even after the Great Depression, he remained committed to gold convertibility in part, to protect the interests of the creditors. He identified several benefits of the gold standard including its simplicity, strong confidence by the public, an automatic mechanism needing little management, the homogeneity in the monetary standard (i.e., gold), and its stability. Kemmerer recognized some of its weaknesses such as its rigidity or cost but did not think these undermined or offset in any way its benefits (Kemmerer 1944).

The central banks’ mandates included the exclusive right of note issue, the centralization of the gold reserve, maintaining the functioning and stability in the payment systems, and, also, providing limited finance to the government (see Table 1). Kemmerer also thought that a gold standard regime required an improved control and performance of public finances. To this end, the missions also introduced fiscal measures alongside currency and banking reforms. These included, among others, initiatives and laws to strengthen the supervision of the government budget and restrain the scope for discretionary spending, increase the efficiency of the tax and tariff system and the introduction of income and property taxes, and oversee the railroad administration. Some of these measures were aimed also at protecting American economic interests. In the case of Colombia, Kemmerer proposed, in 1930, a tax on the export of bananas benefiting the United Fruit Company that held the monopoly of Colombian banana trade (Seidel 1972; Drake 1989).
Table 1

Year of creation and functions of selected central banks in Latin America

Argentina

Ecuador

Chile

El Salvador

Colombia

Peru

Law 12.155, (1935):

Organic Law of the Central Bank of Ecuador (2927):

Law 486 (1925):

Law that Creates the Reserve Central Bank of El Salvador (1934):

Law 25 (1923):

Law 4500 (1922):

 Issue the domestic currency

 Issue the national currency

 Issue the national currency

 Issue the domestic currency

 Issue the national currency

 Monopoly of currency issue

 Regulate the amount of money and credit in line with the needs of the economy

 Act as lender of last resort (LOLR) to the banking system

 Conduct rediscount and discount operations with banks and the general public

 Control the volume of credit and the money supply

 Conduct rediscount and discount operations with banks and the general public

 Conduct rediscount and discount operations with banks and the general public

 Accumulate sufficient international reserves to moderate the adverse effects of exports and foreign investments and preserve the value of the currency

 Conduct rediscount and discount operations with banks and the general

 Provide financial assistance to the public sector on a limited basis

 Preserve the external value of the currency

 Provide financial assistance to the public sector on a limited basis

 Discount and rediscount commercial paper, treasury bonds, and other financial instruments

 Preserve appropriate conditions of liquidity and credit and apply the legislation on the banking system

 Provide financial assistance to the public sector on a limited basis

 Work as a fiscal agent

 Act as a fiscal agent and receive deposits from the government

 Work as a fiscal agent

 Define discount rates

 Act as fiscal agent and advisor for the management of public debt

 Work as a fiscal agent

 Receive deposits from banks, the public sector, and the general public

 

 Receive deposits from banks, the public sector, and the general public

 Provide clearing for payments

 

 Receive deposits from banks, the public sector, and the general public

 Provide clearing for payments

 

 Provide clearing for payments

 Provide financing to the government on a limited basis

 

 Define the rediscount rate

 Define the rediscount rate

 

 Define the rediscount rate

 
 

 Provide clearing for payments

    

Source: Jácome 2015; Flandreau 2003

The main result of the Kemmerer mission was the increase in foreign investment and lending. Available data in the case of Colombia show that, while in 1914 foreign investment had reached US$ 60 million, it increased to US$ 236 million for the period 1926 to mid-1928 (Daalgard 1980). In the case of Chile, between 1927 and 1928 foreign loans increased from US$ 228 to 513 million (Glaser 2003, p. 173).

At the same time the missions did not necessarily lead to improved economic performance or macroeconomic management. Evidence available in the case of Chile shows that after the implementation of the gold standard in 1925 until the start of the Great Depression in 1930, GDP, mineral production, and industrial production registered positive growth only in 1928 and 1929. Equally, public debt expanded from 2,767 to 4,105 million pesos and the country also experienced a current account deficit (350 million pesos at the end of 1929). The country eventually defaulted on its debt in 1931 and, as other countries with Kemmerer-style central banks, went off the gold standard.

The Beginnings of Countercyclical Monetary Policy

The Great Depression and its negative effects led central bank to shift course toward a more proactive, and in some cases explicitly countercyclical, monetary policy stance. This change in policy orientation is reflected in the introduction of new legislation expanding the scope of action and discretionary power of central banks. This marked the beginning of modern central banking in Latin America.

The reform of the laws of the Mexican and Chilean central banks in the early 1930s provide partial illustrations of this trend. In April 1932, the Bank of Mexico began using rediscounting as a policy to manage liquidity and promote economic development, becoming de facto a Central Rediscount Bank. In 1931–1932 the Bank of Chile adopted exchange controls and multiple exchange rates, introduced the use of the rediscount, and financed government development initiatives.

The Central Reserve Bank of El Salvador (1934) was created as an orthodox institution in similarity with the Kemmerer banks but eventually was allowed to undertake open-market operations. Another case in point is the Central Bank of Venezuela (1939) that was given discretionary powers to grant credit to the banking system and the public and allowed to use rediscounting to finance temporary budget deficits (Triffin 1944).

Apart from these examples, the story of the creation of the Central Bank of Argentina (BCRA), its distancing from the orthodox position advocated by the British monetary doctor Otto Niemeyer (1883–1971), and its evolution toward a definite countercyclical stance provide the most representative cases of this change in monetary policy. The BCRA was created in May 1935, and Raúl Prebisch, who was also responsible for drafting the bank’s project proposal, was appointed its first general manager. The BCRA took on the functions of the Currency Board, the Treasury, and those of the Office for the Control of Exchanges, with the exception of the dealings with exporters and importers.

The BCRA was conceived as an institution independent of the government to avoid the creation of excess money supply due to fiscal deficits and to permit a more rational distribution of monetary functions and more efficient management of its policy of reserve accumulation, whose main objective was monetary stability, along conventional lines. The evolution of the BCRA’s monetary policy is marked by three stages, namely, (i) 1935 to the first half of 1937, (ii) second half of 1937–1941, and (iii) 1941–1942 (Prebisch 1991; Pérez Caldentey and Vernengo 2018).

The first stage (1935 to the first half of 1937) consists in central bank interventions (including open-market operations, the creation of a foreign exchange fund and its use to repay external debt, and moral suasion) to limit excessive credit growth and the overheating of the economy in the boom phase of cycle. This period was characterized by a favorable international context which translated into increased exports and in the stock of international reserves increasing the overall liquidity in the economy.

The second stage (second half of 1937–1941) was triggered by the decline in economic activity accompanied by a worsening of the balance of payments position. This stage consists in the realization that central banks must intervene not only in the boom phase but also during the recession through the expansion of credit. To this end, the BCRA resorted to exchange controls to dampen import growth and protect the balance of payments position.

In the third stage, the BCRA prioritized the full employment of resources while insulating the economy from external shocks. It was devised in 1941 as a result of Argentina’s loss of its export markets during World War II, which translated into a severe balance of payments restriction and the fear of general economic prostration. Exchange controls were perfected and became a key monetary policy instrument.

This third stage provided the setting to devise a nationally autonomous monetary policy with the aim of providing a more stable level of economic activity, reduce the vulnerability to external shocks, and ensure the most favorable conditions to fulfill the growth potential of the economy. This monetary policy consisted, on the one hand, in ensuring the provision of sufficient purchasing power through the extension of domestic credit to offset the impact of a fall in exports or decline in foreign financial flows on the economy. On the other hand, it contemplated the application of exchange controls to ensure that the expansion of credit would not lead to a disequilibrium in the balance of payments. Exchange controls also mitigated the potential effects of exchange rate depreciation which included a rise in the cost of living, the extraordinary benefits accruing to some sectors of the economy, and the protection without discrimination of the national industry.

The exchange control proposal sought to differentiate between the categories of imports that should adapt to the business cycle from those that should be isolated from business cycle fluctuations. To this end, the government would establish a hierarchical order of the different import categories and, according to the circumstances, would prioritize the imports most needed to fulfill essential needs and carry out production. The exchange control scheme sought to control imports by varying the exchange rate rather than by quantitative controls seen as too complicated to implement and economically inefficient. The exchange control scheme would be implemented through a process of auctions.

Another Round of Monetary Doctoring in Latin America

The adoption of a countercyclical monetary policy became a generalized practice in the 1940s as the State took on a leading role in intervening and guiding the direction and pace of economic development until the Debt Crisis of the 1980s. This development strategy was underpinned by the Good Neighbor policy adopted by the United States toward Latin America, based upon nonintervention and noninterference with its domestic affairs and which evolved into one of active financial and economic cooperation (Helleiner 1999).

The Federal Reserve Board (FED) provided technical assistance on monetary and financial issues to several Latin American countries including Cuba (1942) and under the lead of Robert Triffin (1911–1993) to the Dominican Republic (1946), Ecuador and Guatemala (1945–1946), Honduras (1943), and Paraguay (1943–1944). Triffin broke with the monetary doctoring of the 1920s whose principles, he thought, had been “artificially transplanted and implemented to an entirely different environment from that of the great financial centers where it developed historically,” thus resulting in a failure (Triffin 1947).

Triffin argued that the problem of monetary management in Latin America was determined by a dominating influence of trade and financial flows on the domestic economy, the erratic nature of fluctuations in the balance of payments, the conflicts between fiscal and monetary policy derived from the dependence of the government on central bank credit, and the absence of well-developed financial markets which made useless and inefficient the use of the traditional monetary policy instruments. The imposition of rigid monetary standards deprived these countries of their monetary management capacity. Thus, they were forced to adapt pro-cyclically to external shocks which aggravated their intensity and effects on monetary and real variables (Triffin 1944, 1947).

He considered his advisory expert missions to Latin America to be truly revolutionary as these placed the central bank and the financial system at the service of economic and social development, rather than trying merely to imitate the Bank of England or the US Federal Reserve model (Wallich and Triffin 1953; Triffin 1981). According to the specific circumstances at hand, his monetary proposals included the use of reserve accumulation, capital regulation measures, the establishment of foreign exchange controls, and an active policy of rediscount and advances as means to confront external shocks and dampen the fluctuations of the business cycle. In some cases, Triffin recommended that central banks should allocate medium- and long-term lending to productive sectors.

The most emblematic case of this new approach to monetary doctoring is that of Paraguay. The reform proposal included adapting the functions of the Central Bank to the needs of the domestic economy, breaking with the traditional rules of linking the monetary issue to international reserves, and ensuring an adequate distribution of credit according to the best interests of the country. Accordingly, the reform gave ample and indeed unprecedented powers to the Central Bank to carry any type of operation in monetary, exchange rate, and credit. This included the provision of medium-term and long-term credit to agriculture and industry and also long-term mortgage loans.

To isolate the domestic economy from external shocks, the reform proposed the use of several instruments, including the buildup of a stock of international reserves, foreign exchange sterilization operations, capital controls, and also exchange controls. The exchange control legislation was drafted by Raúl Prebisch, who was invited by Triffin to join in the spirit of the legislation prepared for Argentina.

Another well-documented case of banking and monetary policy reform is that of the Dominican Republic that gave ample powers to the central bank including the adequate distribution of credit among the different economic activities. The legislation also contemplated the use of capital controls and exchange controls through a system of licensing of credit and investment operations and the transfer of funds abroad.

Monetary Policy During the Developmental Period

In the 1940s other central banks in Latin America – including those of Chile, Colombia, Peru (originally created by the Kemmerer missions), Guatemala, and Mexico – also put economic development (along with price stability) as a central policy objective. Two of the main monetary policy instruments to fulfill this goal were capital controls and reserve requirement. These tools were also used to weather external shocks. In addition, in some cases (in particular in Colombia, Mexico, and Peru), the government through the Minister of Finance was actively involved in determining monetary policy guidelines.

Capital controls, which took the form of differentiated and multiple exchange rates for foreign current and capital exchange transactions, as well as between public and private sector or between residents and nonresidents, allowed greater policy autonomy to limit shocks in the foreign exchange market, favor investment in some sectors, and promote the domestic ownership of specific activities. Capital controls were also used to promote a process of inward industrialization.

Capital controls were combined with the use of unremunerated reserve requirements (in some cases established or modified by the government) to direct credit (through the purchase of government securities) to specific economic activities and, also, to finance the government deficit. Data show that in Argentina loans to the government represented 5% of total domestic credit in 1950; this had increased to 70% by 1970. Similarly, in the case of Peru loans to the government fluctuated between 50% and 60% in the same period.

Central Bank legislation established a minimum and maximum limit for the rate of reserve requirements that applied to different bank liabilities, left open the possibility of introducing marginal reserve requirements rates, and specified the type of assets (not only cash and deposits but also securities) that qualified as reserves. Quantitative controls were used to avoid excessive credit growth to control inflationary pressures. Qualitative controls were used to allocate credit to productive activities through the rediscount of commercial bank paper at the central bank. Credit quotas for commercial banks were established on the basis of their capital, and differential interest rates were granted depending on the loan maturity and the type of economic activity (Jácome 2015).

During this period the Central Banks of Costa Rica (1950), Honduras (1950), Nicaragua (1960), Brazil (1964), and Uruguay (1967) were established. Prior to the establishment of their respective central banks, Costa Rica, Uruguay, and Nicaragua had state banks that mixed central bank with commercial, agricultural, and mortgage banking activities (Triffin 1944).

In this period, the process of state-led industrialization was to a certain extent stimulated by American cooperation within the context of World War II, first, and then later during the Cold War. As a consequence, many Latin American countries also created development banks. The Brazilian Banco Nacional de Desenvolvimento Econômico e Social (BNDES) is emblematic of that period. As noted in Tavares et al. (2010), the bank was one of the suggestions made by the report of a joint US-Brazil mission, which was concerned with increased rates of inflation. The mission recommended credit restrictions, but supported the creation of an investment bank to promote the infrastructure projects included in the report. This developmental period also coincided with an increase in inflation rates, mainly in South America as exemplified by the cases of Argentina, Bolivia, Brazil, Chile, and Uruguay. Between 1945–1955 and 1975–1979, the rates of inflation for Argentina and Uruguay increased from 20% to 204% and from 9% to 60.3%, respectively. In the case of Chile, inflation expanded from 28.4% to 227.1% in 1970–1975. For Brazil, the available data shows a rise in inflation from 14.7% in 1945–1955 to 101% in 1981. Finally, for Bolivia inflation creeped up from 40.4% in 1945–1955 to 123% in 1982 (Table 2).
Table 2

Annual inflation rates for Latin American countries, 1935–2016. In percentages

 

1935–1945

1945–1955

1955–1965

1965–1970

1970–1975

1975–1979

1979–1992

1993–1996

1996–2000

2000–2010

2010–2016

Argentina

2.2

20.0

30.6

13.3

62.4

227.6

594.8

4.6

−0.1

8.8

10.2

Bolivia

21.4

40.4

39.5

13.2

19.4

10.1

993.0

9.8

6.3

4.8

5.2

Brazil

9.8

14.7

40.7

28.1

626.9

1021.4

7.6

6.7

6.8

Chile

13.1

28.4

34.8

135.7

227.1

150.4

22.2

9.9

5.2

3.2

3.2

Colombia

7.9

9.3

10.1

13.1

16.8

23.8

24.7

21.7

15.6

5.9

3.8

Costa Rica

7.7

5.2

2.0

2.6

12.5

8.0

25.0

16.0

12.7

10.4

3.7

Dominican Republic

16.3

2.8

1.3

1.3

9.8

9.6

22.8

7.9

6.5

12.5

4.1

Ecuador

15.7

12.1

1.9

8.6

12.2

12.2

35.8

29.9

47.9

16.5

3.6

Guatemala

9.3

7.6

0.2

1.4

7.6

11.2

15.5

10.5

7.6

6.7

4.1

Honduras

4.3

4.2

1.6

1.8

5.9

7.9

10.9

21.4

16.1

7.9

4.8

Nicaragua

34.3

6.3

1.4

1.7

16.0

14.9

1960.1

12.4

11.0

8.4

5.9

Peru

8.9

13.1

8.3

11.8

11.5

43.9

917.5

23.7

6.9

2.5

3.1

Paraguay

11.6

41.6

10.3

6.3

9.7

11.9

21.9

15.5

8.8

7.9

4.5

El Salvador

6.7

6.5

0.7

1.1

7.9

13.1

17.8

12.2

3.9

3.3

1.4

Uruguay

5.0

9.1

25.4

62.8

62.1

60.3

66.1

42.4

13.9

8.4

8.4

Venezuela, RB

3.7

3.6

0.5

1.6

5.2

9.0

24.9

64.7

45.1

21.7

79.3

Source: On the basis of World Bank (2018)

However, with the exception of Bolivia, the highest inflations on record were experienced in the 1990s after the Debt Crisis of the 1980s as regional GDP per capita growth contracted in the next 3 years (by −1.8%, −3.6%, and −4.7% in 1981, 1982, and 1983, respectively). In the case of Bolivia, inflation kept on increasing after 1983 to reach 11,750% in 1985. The median annual rate of inflation for main countries (Argentina, Bolivia, Brazil, Chile, and Uruguay) reached 9.8% for the period 1935–1945, increasing to 34.8% between 1955 and 1965, reaching a peak of 594.8% in the period 1979–1992. Within this grouping the most renowned cases include Brazil (1,021.4% in 1993–1996), Bolivia (993% in 1979–1992), Peru (917.5% in 1979–1992), and Argentina (594.8% in 1979–1992). These high inflation cases were in general termed hyperinflation cases (a monthly rate of inflation ranging above 50 for at least a year), in similarity with the rates of inflation experienced by some European countries after World War I and World War II, although the historical similarity is highly questionable.

The rise in the prices of some the hyperinflation European countries or African countries is much higher than those in Latin American countries. The record rate of inflation is attributed to Hungary, which between August 1945 and July 1946 recorded an average rate of inflation of 19,800% per month with an extreme of 4.2•1016% in July 1946. More recently, in November 2008, Zimbabwe nearly reached these levels (7.96•1010%). In Latin America, the record monthly inflation rate stands at 397% (Peru, August 1990). Also, European hyperinflations lasted in general a year, much longer than the so-called hyperinflations in Latin America which were observed only for a few months. Moreover, because of their duration, some European hyperinflation affected the level and composition of GDP. Germany’s hyperinflation (Sept. 1922 to Nov. 1923) was accompanied by capital accumulation, very low unemployment levels, and the vertical integration of industry. At a closer inspection, the Latin American inflations turn out to be nothing more than high and extremely volatile case of inflation. The “hyperinflationary” misnomer served to justify drastic adjustment programs and a change in the orientation of monetary policy.

The Causes of Inflation and the Monetary Policy Prescriptions

The increasing concern with inflation as a disruptive force gave rise to two different and opposing interpretations regarding its origins and persistence: the structuralist and monetarist explanations. According to the former, inflation has its roots in the real rather than the monetary sphere (Furtado 1952; Noyola Vásquez 1956; Sunkel 1958). The canonical model of structural inflation separates inflationary pressures into basic, circumstantial, and cumulative pressures. Inflationary pressures are the initial causes of inflationary processes, while the propagation mechanisms maintain inertia or give strength (in the physical sense) to that process.

Basic pressures include the external constraint, deteriorating productivity, mediocre investment performance, an inadequate infrastructure system, and a tax system that is unable to cope with the needs of a modern society. Circumstantial pressures refer to exogenous events or decisions, while cumulative pressures are endogenous to inflation. The endogeneity of inflation allows incorporating the feedback from inflation to other variables while giving a dynamic character to the structural approach. The mechanism of propagation par excellence is the distributive struggle between the different agents/sectors of the economy, often associated to some form of formal wage indexation mechanism.

The opposite view, which was the one adopted by the central banks in the region, centered on the quantity theory of money and attributed the rise in process to excess supply over money demand. The excessive money was generally attributed to fiscal deficits. As is well known, the budget constraint is defined as:
$$ G-T+ rB=\frac{dB}{dt}+\frac{dM}{dt} $$
(1)
where G is the level of government spending (excluding interest on government debt), T is the income from taxes, r is the interest rate of government debt (B), and M is the level of high-powered money (monetary base).

When governments are constrained in their ability to increase taxes or access the capital market, government deficits are financed by increasing high-powered money (\( \frac{dM}{dt}\Big) \). The rise in high-powered money and money supply places a tax – the inflation tax – on cash balances by depreciating the value of money. The government revenue from inflation (i.e., GRI) is equal to the inflation rate (π) times the demand for real cash balances (\( \frac{M}{P}\Big) \). At zero inflation rate, the inflation tax revenue is also zero. As the rates of inflation become positive, the inflation tax revenues increase provided \( \frac{M}{P} \)remains constant or as long as the increase in inflation offsets the decrease in real cash balances. During inflation real cash balances tend to decrease as agents try to avoid the tax on cash balances (the inflation tax).

At a certain point, the tendency for the demand for real cash balances to decrease will overwhelm the effect of the inflation tax, and it will cease to bring in revenue. The point of inflection of the inflation tax revenue curve is the point at which the inflation tax revenue is maximum, the point corresponding to the optimal inflation rate. Once the optimal rate is trespassed, inflation tax revenues decrease. As the inflation tax revenues decrease, prices will continue to increase, and the government will move to cover its financial needs by printing more money, thus increasing the inflation rate. This, in turn, through its effect on real cash balances will decrease the inflation tax revenues further.

Other explanations developed in the aftermath of the structuralist-monetarist debate on inflation traced its rise to balance-of-payments crises brought about by capital outflows, terms-of-trade shocks, and/or currency overvaluation. During the period several Latin American countries experienced either a currency or sovereign debt crisis. Laeven and Valencia (2012) register 9 and 24 currency crises in the 1980s and 1990s (Table 3). In some instances, balance-of-payments crises were accompanied with banking crises.
Table 3

Systemic banking, currency, and sovereign debt crises for Latin American and Caribbean countries 1970–2010

Country

Systemic banking crisis (starting date)

Currency crisis

Sovereign debt crisis (default date)

Sovereign debt restructuring (year)

Total crises per country

(year)

 

By country

Argentina

1980, 1989, 1995, 2001

1975, 1981, 1987, 2002

1982, 2001

1993, 2005

12

Bolivia

1986, 1994

1973, 1981

1980

1992

6

Brazil

1990, 1994

1976, 1982, 1987, 1992, 1999

1983

1994

9

Chile

1976, 1981

1972, 1982

1983

1990

6

Colombia

1982, 1998

1985

3

Costa Rica

1987, 1994

1981, 1991

1981

1990

6

Dominica

2002

n.a.

1

Dominican Republic

2003

1985, 1990, 2003

1982, 2003

1994, 2005

8

Ecuador

1982, 1998

1982, 1999

1982, 1999, 2008

1995, 2000, 2009

10

El Salvador

1989

1986

2

Guatemala

1986

1

Guyana

1993

1987

1982

1992

4

Haiti

1994

1992, 2003

3

Honduras

1990

1981

1992

3

Jamaica

1996

1978, 1983, 1991

1978, 2010

1990, 2010

8

Mexico

1981, 1994

1977, 1982, 1995

1982

1990

7

Nicaragua

1990, 2000

1979, 1985, 1990

1980

1995

7

Panama

1988

1983

1996

3

Paraguay

1995

1984, 1989, 2002

1982

1992

6

Peru

1983

1976, 1981, 1988

1978

1996

6

Suriname

1990, 1995, 2001

3

Trinidad and Tobago

1986

1989

1989

3

Uruguay

1981, 2002

1972, 1983, 1990, 2002

1983, 2002

1991, 2003

10

Venezuela

1994

1984, 1989, 1994, 2002, 2010

1982

1990

8

Decade

Averages

1970s

1

9

2

0

1980s

12

24

16

1

1990s

14

14

1

17

2000s

4

8

6

6

Source: Data file to accompany the IMF Working Paper “Systemic Banking Crises Database: An Update” Laeven and Valencia 2012. https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Systemic-Banking-Crises-Database-An-Update-26015

Balance-of-payments crises led to devaluation of the currency which led inevitably to inflation through different channels, including increase in the imported cost components of goods, expectations of further devaluation, the rise in the cost of servicing external debt, and loss of capital gains in the domestic bond market. These set the stage for further increase in prices through increases in nominal wages, further exchange rate devaluations and through the increase in the budget deficit and in the money supply. Other variables that also lend themselves to explain inflation dynamics include dollarization, capacity constraints, and indexation.

The onset of the 1980s Debt Crisis, which is considered the worst crisis episode to hit the region since the 1930s Great Depression, produced a Copernican turn in economic and monetary policy. Latin American countries adopted Washington Consensus policies which consisted mainly in maintaining fiscal discipline, liberalizing trade and financial markets, deregulating the economy, and privatizing state-owned industrial firms and public utilities (Williamson 1990).

Within this context the preferred approach to deal with inflation and to formulate stabilization policies was the monetary approach to the balance of payments (MABP). This viewed inflation and balance of payments deficits as a result of a disequilibrium in the money market (mainly generated by budget deficits) and hence as a monetary phenomenon (Polak 1957; Frenkel and Johnson 1976; International Monetary Fund 1977; Kreinin and Officer 1978; Mundell 1968). The chain of causality ran from budget deficits to credit expansion to increasing real cash balances and a rise in absorption above domestic output, inducing both inflation and a deficit in the balance of payments. The adjustment is brought about by changes in the stock of foreign reserves which drives the supply of money. A deficit (surplus) in the balance of payments produces a decline (increase) in the stock of foreign reserves leading to a reduction (rise) in the money supply resulting in a reduction (increase) in absorption until it conforms to the level of output. With all its assumptions (the world is an integrated capital and commodity market; domestic price levels conform through competition to a one-world price level; the price level is pegged to the world price level moving rigidly in line with it; full employment), the MABP has important implications for monetary policy.

First, the relevant control variable is the rate of growth of credit rather than the rate of growth of the money supply. Second, the world rate of inflation is determined by the world money supply. As long as countries maintain pegged or fixed exchange rates, they cannot avoid conforming over time to the world price level. Third, fiscal and monetary policies do not have any effect on real aggregate output. Fiscal policy can only change the composition of government expenditure and the proportion financed by debt. For its part monetary policy has no control over the money supply; it is an endogenous variable (the public adjusts the nominal supply of money to its demand by exporting or importing money via the balance of payments). Monetary policy can only determine the composition of the money supply between net domestic assets and international reserves. Fourth, international reserve growth is positively related to domestic growth and the income elasticity of demand for money. Finally, the effects of a devaluation are akin to those of a deflationary policy stance. A devaluation of the currency increases domestic prices, ipso facto, through the law of one price and translates into a decrease in real cash balances. Economic agents’ restoration of their desired level of real cash balances leads to an increase in lacking (to use the Robertsonian term) and a lower level of expenditure.

The Change of Orientation in Monetary Policy

In line with these changes, central banks in the region reformed their legislation placing price stability as the primary objective of monetary policy excluding any reference to the promotion of economic development or growth through monetary means. To this end central banks had to be free from political interference in the design and implementation of monetary policy including from the constraints derived by lending to the government to cover fiscal deficits. This implied both political and operational independence.

Political independence materialized in granting tenure periods to the board of directors coinciding or exceeding those of governments. Also, the board of directors does not include representatives from the government or private businesses. A government representative, generally the minister of finance, is permitted to sit in the meetings of the board of directors but does not have voting power. Furthermore, the legislative branch plays an important role in either appointing or confirming the members of the board of directors. Finally, the reformed legislation sought to provide greater control of central bank’s actions by the periodic reporting of central bank actions, aims, policy implementation and results, and financial statements (for the most part certified by an external source to the central bank). In some cases, the legislation also included hearings before the legislative branch to explain monetary policy reports (Table 4).
Table 4

Key features of central banks following the reforms of the 1990s

Main objective

Price stability as the sole or primary objective

Price stability plus other objectives, with no indication of priority

Operation of the payment system

Stability of the financial system

Growth or economic development

Argentina (1992), Bolivia (1995), Colombia (1992), Costa Rica, Dominican Republic, Mexico (1993), Peru (1993), Venezuela

Chile (1989), Honduras, Nicaragua

Guatemala, Paraguay, Uruguay

Brazil

Credit to the government by the central bank

No direct or indirect credit, or credit extended on the secondary market with limits

Credit to cope with seasonal liquidity shortages, or credit extended on the secondary market without limits

Direct credit

Argentina, Chile, Costa Rica, Brazil, Dominican Republic, Guatemala, Peru, Uruguay, Venezuela

Bolivia, Honduras, Mexico, Nicaragua, Paraguay

Colombia

Independence in the use of monetary policy instruments

Full independence in monetary and exchange rate policy

Restrictions on the conduct of monetary or exchange rate policy

Monetary and exchange rate policy set by the government

Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Honduras, Nicaragua, Peru, Uruguay

Guatemala, Mexico, Paraguay, Venezuela

 

Financial independence

Government is required to maintain central bank’s capital

Government is authorized but is not required to capitalize the central bank, or capitalizes it with nonnegotiable bonds

No legal basis exists for the government capitalizing the central bank

Brazil, Colombia, Dominican Republic, Guatemala, Nicaragua, Peru, Venezuela

Bolivia, Chile, Mexico

Argentina, Costa Rica, Honduras, Paraguay, Uruguay

Reporting by the central bank

Formal appearance before the legislature

Submission of a report to the executive or legislative branch, or publication of a report in the news media

Argentina, Brazil, Chile, Colombia, Dominican Republic, Guatemala, Mexico, Paraguay, Venezuela

Bolivia, Costa Rica, Honduras, Nicaragua, Peru, Uruguay, Mexico

Publication and transparency of information

Financial statements certified by external auditors

Financial statements certified by a public agency separated from the central bank

Financial statements signed by an auditor appointed by the central bank’s executive board

Argentina, Chile, Guatemala, Mexico, Nicaragua

Brazil, Colombia, Honduras, Paraguay, Uruguay, Venezuela

Bolivia, Costa Rica, Dominican Republic, Peru

Source: Latin American national constitutions and central bank legislation as of 2003, and Fiscal Responsibility Law in Brazil; Carstens and Jácome 2005; Schmidt-Hebbel 2011

During the 1990s, the three-digit (or higher) inflation rates disappeared in the region, and the majority of Latin American and Caribbean economies witnessed a decline in their inflation, in line with global developments. The average rate of inflation fell from 336% (1979–1992) to 82.8% (1993–1996) and finally to 13.4 (1996–2000). In the period 1979 to 1992, no country in Latin America had a one-digit inflation rate. In 1993–1996, four countries had a one-digit inflation rate, and in the period 1996–2000, half of the countries in Latin America reported one-digit inflation rates. These became the norm in the 2000s. The decline in inflation was worldwide rather than a phenomenon specific to Latin American countries.

In the particular case of Latin America, both countries that introduced changes in the bank legislation in the 1990s and those that did not witnessed a decline in the rate of inflation. In the 1990s central banks in the region faced two significant challenges. First, central banks often targeted the nominal exchange, leading them to have two nominal anchors: the nominal exchange rate and the price level. The second challenge was that, in the 1990s, central banks continued to deal with financial and banking crisis.

The existence of two policy targets could lead to important contradictions and inconsistencies in the formulation and implementation of monetary policy. This can be justified by the fact that in small open economies, the exchange rate plays a key nominal and real role and that the monetary authority or central bank cannot be oblivious to its fluctuations. Nonetheless, maintaining two nominal anchors can pose significant inconsistencies in monetary policy objectives. For one thing, stabilizing the exchange rate can, under certain conditions, e.g., in the case of external shocks, take precedence over inflation. Also, seeking to stabilize the exchange rate or giving priority to the external sector (maintaining external competitiveness) over domestic conditions can lead to a pro-cyclical policy amplifying real and nominal fluctuations.

The importance of the external sector and the way in which it can enter into conflict with inflation objectives is illustrated by the Chilean experience in the 1990s. During this time the authorities implemented several discretionary and ad hoc modifications to the exchange rate regime in an effort to control exchange rate fluctuations. These weakened some of the very same elements that form part of the core of the new framework in monetary policy adopted in the 1990s, namely, transparency and communication.

Chile adopted in 1991–1992 a crawling peg in relation to the dollar accompanied by daily devaluations according to the internal-external inflation differential. Thereafter, the exchange rate regime switched to a target zone around a basket peg. The central parity was tied to a basket of currencies including the US dollar, the Deutsche mark, and the Japanese yen. Thereafter until 1999, there were several and frequent modifications to the central parity, to the currency basket weighs, and to the bands. In fact, overall from 1992 until 1999, there were ten different changes to the parameters of the exchange rate target zone regime. The main difficulty with the exchange rate regime and the different changes was the fact that it was very hard on the basis of the information provided for market participants to know or understand the type of exchange rate regime that prevailed at the time.

Also, as noted above, financial and banking crisis were prevalent in the 1990s. The available data for 24 Latin American and Caribbean countries show only one sovereign debt crisis corresponding to Ecuador, which as a result dollarized its economy. El Salvador and Panama are the other two countries that have a dollarized economy, while Argentina reinstituted a Currency Board and kept a fixed exchange rate to the dollar. This is a sharp drop from the 16 cases registered in the 1980s. However, in both the 1980s and 1990s decades, currency crises persisted (24 and 14 for the 1980s and 1990s, respectively), and the number of systemic banking crisis increased (12 and 14 cases for the same periods, respectively).

The most significant crises episodes in the region include the Mexican “Tequila” (1994–1995), the Brazilian (1999), and Argentinean (2001–2002) crises. The Tequila crisis, whose epicenter was Mexico, had contagion effects mainly in Argentina and to a lesser extent in Brazil. Mexico and Argentina’s GDP per capita growth fell by −8.0 and −4.1%, respectively. The contagion effects of the Asian crisis and Russian-Brazilian were felt throughout emerging market economies and in Latin America affected Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. Finally, the Argentinean crisis (Argentina recorded a contraction of 5.5% and 11.9% in real GDP per capita in 2001 and 2002) impacted on Brazil, Paraguay Peru, Uruguay, and Venezuela.

The comparative analysis of these three episodes shows important common features across country experiences prior and during to crises/contagion episodes. The evidence indicates that prior to the year in which the crises materialized or the year the contagion effects were felt, the government accounts registered declining imbalances. Also, the year prior to the crisis or the year in which contagion effects were felt, the government had either a mild fiscal deficit or a surplus. Contrarily, the private sector recorded a widening imbalance, and this was a major source of vulnerability. The private sector deficit was reflected in the current account. In the majority of cases analyzed, the rest of the world constitutes an important source of liquidity for the economy and is an important source of finance to cover the private sector’s deficit.

The crises/contagion transmission mechanisms include in general a decline in external provision of finance, the contraction in domestic credit, and the deleveraging by the private sector. The government sector does not show, across the different episodes analyzed, a common pattern of behavior, although in some cases the fiscal accounts tend to deteriorate as a result of lower growth of the economy and thus of government revenue. For its part, the policy reaction of the monetary authority is pro-cyclical and illustrates the standard approach to confront crises/contagion episodes. The evidence shows that the central bank restraining rather than providing liquidity to the private sector during the crisis episodes, to counteract the fall in spending. The central bank did provide extra financing to the financial sector in order to maintain financial stability. But in no case is the extra financing to the financial sector a source for the provision of countercyclical liquidity for the economy (Pérez Caldentey and Cruz 2017).

The Adoption of Inflation Targeting

Since the 2000s Latin American countries have turned to inflation targeting strategies (Table 4). Inflation targeting is traditionally defined as a monetary policy strategy framework consisting in the public announcement of numerical targets for the inflation rate, acknowledging that price stability (a situation where the inflation rate at which inflation is no longer a public concern, Clarida et al. 1999) is the fundamental goal of monetary policy and a firm commitment to transparency and accountability (Bernanke et al. 1999; Svensson 2010). The main instrument of monetary policy is the management of the short-term interest policy rate through a Taylor type policy rule (Eq. 4 below).

Within the context of this definition, numerical targets can refer to a point inflation rate, a range or a point with a tolerance range. The inflation rate can refer to the consumer price index (CPI) as is the standard case for most developing economies or to the core CPI. In an open economy, inflation targeting favors a free-floating exchange rate regime to avoid having two nominal anchors which can lead to the type of contradictions that surfaced in some Latin American countries in the 1990s (described in the section above). Within an inflation targeting regime, external shocks, which are one of the main sources of volatility and cyclical fluctuations, are absorbed by movements in the exchange rate thus avoiding the direct transmission from these impulses to the domestic economy.

Transparency means that the monetary authorities must communicate their targets, forecasts of inflation, decisions on monetary policy, and the motivation for their decisions. Finally, accountability here means that the monetary authorities are responsible for attaining the announced objectives and subject to “public scrutiny for changes in their policy or deviations from their targets.”

The canonical model of inflation can be stated as follows:
$$ {y}_t^g=f\left({y}_{t-i}^g,{y}_{t+i}^g\right)+f\left({i}_t-{E\pi}_{t+i}\right)+{u}_t $$
(2)
$$ {\pi}_t=f\left({y}_t^g,{\pi}_{t-i,},{E\pi}_{t+i}\right)+{v}_t $$
(3)
$$ {i}_t=f\left({r}^{\ast },E{\pi}_t,{y}_t^g\right)+f\left({\pi}_t-{\pi}^{\ast}\right) $$
(4)
where yg is the output gap (i.e., the difference between actual and potential output), πt,π are actual and target inflation rates, it is the actual short-term nominal interest rates (i.e., the monetary policy rates), E is the mathematical expectation, and ut,vt are random errors.

The inflation targeting framework makes clear that low and stable inflation should not be pursued at any cost. Moreover, monetary authorities do not necessarily have to pursue a rigid inflation targeting regime. Rather they can opt for a “flexible” inflation targeting. The latter implies that the monetary authorities or the central bank do not have only a monetary objective (stabilizing inflation) but have also a real objective (stabilizing real output). The adoption of flexible inflation targeting entails pursuing a gradualist approach to the achievement of monetary policy objectives. Flexible inflation targeting and hence a gradualist approach to monetary policy are conceptually justified mainly on the grounds of uncertainty regarding (i) the workings and current state of the economy, (ii) the transmission mechanisms and policy parameters, and (iii) the nature of external shocks as well. A gradualist policy can also contribute to buffer the effects on real variables caused by external shocks.

Inflation targeting strategies permit monetary authorities to pursue a “lean against the wind” policy while avoiding large fluctuations, and indeed lowering volatility, of output. Within the international setting of the early twenty-first century, this monetary practice must be accompanied by a consistent and coherent fiscal policy without endangering stability or development objectives. This consists in formulating fiscal policy objectives and instruments allowing it to play at the same time a stabilization role while recapturing its distributive role.

Several Latin American countries have tended in the past decade to show their preference for inflation targeting regimes including Brazil (1999), Colombia (1999), Chile (1999), Guatemala (2005), Mexico (2001), and Peru (2002). To those countries that already have in operation a full regime of explicit inflation targets must be added others that are in the process of implementation of the scheme (Costa Rica, the Dominican Republic, Paraguay, and Argentina) (Table 5).
Table 5

Inflation targeting regimes in Latin America

Country

Adoption of target

Inflation measure

Target (2006)

Target horizon

Inflation report

Published forecast

Brazil

June 1999

CPI

4.5% (+/−2%)

12 months

Yes

Yes

Chile

January 1991

CPI

2%–4% centered at 3%

12–24 months

Yes

Yes

Colombia

September 1999

CPI

4%–5%

12 months

Yes

Yes

Mexico

January 1999

CPI

3%(+/−1%)

12 months

Yes

Yes

Peru

January 2002

CPI

2.5% (+/−1%)

12 months

Yes

Yes

Source: On the basis of official information

Costa Rica decided to orient its monetary policy toward an inflation targeting regime in 2005. Paraguay chose to initiate the formal start-up of this scheme in 2011. Meanwhile, the Dominican Republic began its transition to an inflation targeting regime scheme in the 2012. Argentina adopted inflation targeting in 2016, but it seems to have abandoned it, in the midst of the 2018 crisis. Uruguay is an atypical case as much as this country began to implement an inflation targeting scheme in 2007 and decided to reverse toward a quantitative target regime in 2012.

Some Evidence on Latin American Inflation Targeting Regimes

The available evidence shows that inflation targeting regimes do not necessarily practice countercyclicality and do not adhere in general to floating exchange rates. Data for 13 Latin American countries show that the correlation coefficients between the output gap and the monetary policy rate is negative as expected in less than half of the cases considered (Fig. 1).
Fig. 1

Correlation coefficients between the output gap and the inflation rate for selected Latin American economies (circa 1995–2016). Note: The output gap is the difference between actual and potential GDP. (Source: On the basis of Aravena et al. (2018) and World Bank Development Indicators (2018))

At the same time, countries that have adopted inflation targeting regimes show “fear of floating” and frequently intervene in the foreign exchange market. This is illustrated in Fig. 2 for the case of Latin American countries that have in force inflation targeting scheme. The metric used is an index of exchange rate intervention (IIC) (see note below Fig. 2) before and after the adoption of this scheme. The IIC takes values between 0, which reflects a situation of pure flotation, and 1 indicating that the authorities intervene systematically to soften variations in the exchange rate. Although in all countries the degree of exchange rate intervention decreased in the twenty-first century compared to the 1990s (with the exception of Peru), none of the countries considered adheres to a nonintervention scheme. Also, the IIC is for some of these inflation targeting economies close to the 0.73 obtained by Ostry et al. 2012, for developing countries that do not adhere to inflation targeting.
Fig. 2

Exchange rate intervention index for Latin American countries with inflation targeting regimes. 1991–1999 and 2000–2014 (averages). Note: \( IIC=\frac{\sigma_{\Delta international\ reserves}}{\sigma_{\Delta International\ reserves}+{\sigma}_{\varDelta Real\ exchange\ rate}} \), where σ= standard deviation and Δ = xtxt − 4. (Source: On the basis of IMF (2013–2018))

Foreign exchange intervention is due to the fact that in a context of financial openness and globalization, the nominal exchange rate is a price that responds to expected returns (whether profit or potential losses) in future markets. In this sense the exchange rate behaves like the price of an asset. The lack of systematic effectiveness of arbitrage results in a high instability in the exchange market that can only be tackled with a systematic policy of accumulation of reserves. As shown in Table 6, full-fledged inflation targeting countries have increased their stock of reserves as a percentage of GDP.
Table 6

International gross reserves as percentage of GDP for full-fledged inflation targeting countries 1990–2000 and 2001–2017 (averages)

Period

Brazil

Chile

Colombia

Mexico

Peru

1990–1995

5.5

20.9

9.8

12.5

199–62,000

5.9

19.6

8.1

5.0

17.8

2001–2005

7.3

18.2

11.0

7.4

17.9

2006–2009

11.6

12.4

10.1

8.9

25.0

2010–2017

16.2

15.2

12.7

14.2

31.0

Source: On the basis of official information

According to the logic of the inflation target scheme, in the absence of sterilization operations, the accumulation of international reserves translates into an increase in the monetary base and liquidity of the economy, which can pose a threat to the achievement of the inflationary target. In the worst case, it can jeopardize monetary stability and even financial stability. To avoid these risks, central banks tend to sterilize the expansive effect of the increase in net international reserves. The intensity of the sterilization operations can be assessed from the quotient, \( \frac{\Delta \mathrm{AEN}-\Delta \mathrm{CC}}{\Delta \mathrm{AEN}} \), where AEN= NET external assets and CC = Cash.

It reflects the extent to which monetary authorities apply sterilization policies that include not only the extent to which they use bond market interventions to neutralize the effect of stockpile accumulation on the monetary basis but also integrate the variations in the reserves of commercial banks in the central bank to adjust the monetary multiplier (Lavigne 2008). The sterilization ratio fluctuates between 0 and 1. The lower value of the sterilization coefficient (0) reflects a non-sterilization situation, while the higher value (1) refers to a condition of complete sterilization. Table 7 shows the respective sterilization coefficient for Brazil, Colombia, Chile, Guatemala, and Peru for periods 1996–2000, 2000–2006, and 2007–2013.
Table 7

Sterilization coefficient (EC) for Latin American countries with inflation targets 1996–2000, 2000–2006, and 2006–2013 (averages)

País

1996–2000

2000–2006

2006–2013

 

CE

CE

CE

Brazil

0.57

0.58

0.84

Chile

0.92

0.19

0.66

Colombia

n.d.

−0.50

0.45

Mexico

0.85

0.59

0.67

Peru

0.86

0.99

1.00

Note: n.d. = not available

Source: On the basis of IMF (2013–2018)

The evidence shows that in the inflation targeting period, all countries have tended to increase the intensity of their sterilized interventions. Sterilized interventions can put upward pressure on interest rates. The increase in the interest rate is self-corrective in a context of currency depreciation but produces a cumulative effect under a situation of appreciation, which is when most of the exchange interventions take place.

In addition, sterilization policies may have significant quasi-fiscal consequences for the interest rate differential between domestic rates and external rates, which is large for Latin American countries with inflation targets due in part to the low interest rates prevailing in the United States in the decade of the 2000s. In fact, on average in the period 2001–2013, the differentials between the yields of the treasury bonds of the United States and its equivalent for the countries with inflation targets amounted to 10, 6, 1, 3, and 1 percentage points in the case of Brazil, Colombia, Chile, Mexico, and Peru, respectively.

Conclusion

Monetary policy is considered the central pillar of economic policy and the main instrument for economic stabilization and to approximate the actual to the potential level of GDP. As things stand, inflation rates continue to hover, with a few exceptions, notably Argentina and Venezuela, at single digits pushing aside inflation as a macroeconomic threat. Yet in some cases, inflation stabilization has been obtained at the expense of output stabilization. Monetary policy needs to gain an improved understanding of the transmission mechanism between monetary policy and the real economy in a more financially complex context and especially when monetary policy is contractionary.

The existing monetary dominance has been reflected in the adoption of rules in the form of inflation targeting regimes. These schemes that are conceptualized within the framework of the new consensus on macroeconomics have been increasingly imposed in the developing and developed world and have relegated fiscal policy to a secondary level and more specifically, in some cases, to the status of a stochastic error. In turn to avoid the destabilizing effect of this stochastic error, monetary rules have been supplemented with fiscal rules.

This macroeconomic policy poses important costs and risks in both financial and real terms. Fiscal policy has been transformed into a subsidiary policy to the objectives guided by maintaining macroeconomic balances and has paid little attention to fiscal expenditure and its composition, taking for granted the effect of human capital expenditure and physical in long-term growth. In fact, fiscal policy has simply become a social welfare policy. The lack of attention paid to private indebtedness and dependence on external financing exposes the performance and growth trajectory to fluctuations in international financial flows. More importantly, it can generate its own volatility to boom-and-bust cycles, which is exactly what was intended to avoid by subordinating fiscal policy to monetary dominance. Indeed, one of the most important challenges to monetary management in Latin America are the dominating influence of international trade and financial flows on economic activity and the constraints these impose on central bank’s policies. In this sense, financial stability including macroprudential policy which has become a broader and more relevant theme that central banks must be incorporated in central banks’ mandates.

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Copyright information

© Springer Nature Singapore Pte Ltd. 2019

Authors and Affiliations

  1. 1.Economic Commission for Latin America and the Caribbean ECLACSantiagoChile
  2. 2.Bucknell UniversityLewisburgUSA

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