The Tragedy of Current Latin American Monetary Policy

On March 18 the United Nations Economic Commission for Latin America and the Caribbean, ECLAC (www.cepal.org), made public an estimate of the effects food inflation is having on Latin America. Despite rapid economic growth, extreme poverty will increase by ten million people this year! This is a dramatic figure and represents more than half of the reduction in extreme poverty that had taken place during the recent economic boom, from 2004 to 2007.

Food inflation is also making the task of managing of monetary policy extremely difficult. Indeed, the mix of two entirely exogenous shocks –food price inflation and a financial crisis in the US—has created a situation in which monetary authorities are the main actors of an unprecedented tragedy. It is true that the theory of inflation targeting says that temporary shocks, such as those associated with a spike in food inflation, should not lead to a reaction by monetary authorities. But there is a clear risk that higher food inflation will get transmitted to wages and other prices, so monetary authorities cannot simply ignore it. And, of course, some Latin American economies are generating their domestic inflationary pressures after several years of rapid growth. However, given the external origin of food price inflation, a contractionary monetary policy would do little to moderate such inflation.

In the second act of the tragedy, the US Federal Reserve enters the scene. Given the sharp reduction in US policy intervention rates, to manage its own financial crisis and the threat (or, I think along with many others, the reality) of recession, interest rate margins between Latin America and the US have widened significantly. This is, therefore, an open invitation to capital inflows and exchange rate appreciation. Central banks can absorb part of the surplus capital inflows through the accumulation of foreign exchange reserves, as most countries in the region have done, but this seems to have been insufficient, and may have invited further capital inflows. Some measure of prudential capital account regulations (reserve requirements or taxes on capital inflows, following the model used successfully by Chile and Colombia in the 1990s) could help, and Argentina, Colombia and, more recently Brazil, have taken some moderate measures in this regard, but none would be willing to use them to the extent that would be necessary to make a significant indent on capital flows.

So, the major outcome has been exchange rate appreciation. This is shown in Figure 1, in which exchange rates are shown in domestic currency per dollar, so down means an appreciation. Four of the six largest Latin American economies have had significant appreciation in recent months (Venezuela is excluded, as it has a fixed exchange rate). Brazil and Colombia had experienced substantial appreciation earlier on, and the currencies of the two countries now look overvalued. The appreciation of Chile and Peru are in line with that of the euro vis-à-vis the US dollar, but Brazil and Colombia have appreciated even in relation to the euro. Argentina and Venezuela are also experiencing real appreciation, through domestic inflation. So, Mexico seems the only large Latin American economy immune to the current malaise, but it is also the one that would be worst hit by US recession.

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In recent years, one of the most trumpeted aspects of Latin American performance was that the region was running a current account surplus (not all of countries, of course). The mix of rapid growth with current account surpluses has been common in Asia, but it has been unusual in Latin America, at least since the 1970s. It could be said that it was due to high commodity prices, but then in the past Latin America managed to run current account deficits even when commodity markets were booming, such as during the 1970s. Colombia is already running a sizable deficit, and Brazil joined the deficit club in the last quarter of 2007. Furthermore, excluding Venezuela, Latin America will be running a deficit in 2008. And, if we take out the terms of trade shock, the current account deficit had already gone back in 2007 to the levels of the crisis of the late 1990s and the early part of this decade (see Figure 2).

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Source: Author’s estimates based on the database of the United Nations Economic Commission for Latin America and the Caribbean (ECLAC).

Will there be, therefore, a third act of the tragedy in which Latin America returns to its traditional current account deficits and the vulnerability that is associated with them? Certainly the region looks more vulnerable now to the reversal of the favorable terms of trade shock (which, of course, appears solid for the time being). But, furthermore, is nominal appreciation the best that inflation targeting can achieve? If so, it needs a serious revision.

Indeed, ignoring the effects of monetary policy on exchange rates is one of the major flaws of inflation targeting in emerging economies. The elegance of just having one objective looks nice at first, but it ignores the fact that the fundamental challenge of macroeconomic policy is how to manage difficult trade-offs. Multiple objectives and trade-offs also imply the need to use more instruments and to coordinate monetary policy more carefully with fiscal and other policies, which are the responsibility of governments. And, of course, in an orthodox interpretation, a current account deficit is as much a case of excess demand as domestic inflation. Furthermore, and perhaps even more importantly, current account deficits have been an even more important predictor of crises and of the inflationary shocks that accompany large exchange rate depreciations during crises. So, we are back to the basic question: why should inflation be the only objective of monetary policy?

5 Responses to "The Tragedy of Current Latin American Monetary Policy"

  1. Juan Pablo Gelman   May 1, 2008 at 12:56 pm

    Perhaps the point is fiscal policy. Inflation is not the only target in most inflation targeting regimes, the name is due to the fact that the target is inflation not the price level; Taylor rules are designed precisely to weight inflation along with other objectives like GDP stabilization or GDP growth. It can also accommodate a foreign exchange rate objective as Lawrence Ball suggests. Currency appreciations would occur with or without this IT regimes in place because they´re caused by the USA current account imbalances. The best tool now might not be monetary but fiscal policy; using fiscal surpluses to accumulate sizable amounts of foreign reserves is the best way to avoid real appreciations. This or having capital controls so restrictive that would let countries practically isolated. Fiscal surpluses would also help to have lower interest rates and less excess growth over potential hence diminishing inflationary pressures, the problem is that it’s a little late for that. More importantly USA must correct its imbalances faster, it would be good for them; USA net foreign assets have been falling for years, the country is getting poorer and this recession is not correcting these imbalances fast enough.

  2. Andrés Vargas   May 2, 2008 at 10:08 am

    Totally agree. We wrote about it in our last piece, http://www.usergioarboleda.edu.co/observatorio_economico/Artículos%20Económicos/ABRIL/abril_intervencion_cambiaria.html

  3. Javier Guillermo Gómez P.   May 6, 2008 at 4:31 pm

    My reading of Mr. Ocampo’s argument is the following:First act: food inflation will reverse more than half of the reduction in extreme poverty that was achieved in Latin America in 2004-2007. Therefore food inflation in Latin America is a tragedy.Second act: the drop in US policy interest rates appreciates Latin American exchange rates. Exchange rate appreciation is a tragedy. Therefore US monetary policy is a tragedy.Third act: Inflation targeting pursues solely the inflation objective. The second-round effects of food inflation mean that Latin American inflation-targeting central banks will raise interest rates and those higher interest rates mean exchange rate appreciation. Exchange rate appreciation is a tragedy and therefore inflation targeting is a tragedy. I would like to focus on Mr. Ocampo’s “third act:” Sure, if inflation is to be contained, interest rates will have to be raised and the nominal exchange rate will appreciate. Is this a consequence of inflation targeting? Is there any other regime that can prevent exchange rate appreciation? The answers to these questions are no and no and I support my claim as follows:Suppose Latin American inflation targeting countries implement a regime that consists of imposing a floor to the nominal exchange rate (this proposal is in Ocampo, 2008, p.28). By a floor, I mean a limit on nominal exchange rate appreciation. Let us assume there would be no explicit or implicit inflation target and that there is a capital inflow explained by a decrease in the Fed Funds rate that more than offsets any increase in the EMBI spread. As monetary policy would not be independent with a floor on the exchange rate, domestic interest rates would drop, aggregate demand would rise and along with it, inflation. The demand-led increase in inflation would add to the increase in inflation caused by food inflation. The demand-led increase in inflation would also appreciate the REAL exchange rate. Exchange rate appreciation is a tragedy, the argument goes, and then the “exchange-rate-floor regime” would be a tragedy.It could be argued that inflation need not increase because sterilized intervention and increasing reserve requirements could be used to contain credit, aggregate demand and inflation. But domestic and foreign investors will realize that there is a limit to the extent that the monetary authorities can constrain the banking business. Beyond that limit, the central bank has to either abandon the exchange rate floor or let inflation go. On one hand, the self fulfilling breakdown of the exchange-rate floor would be the result of a different kind of speculative attack, a sudden nominal appreciation. On the other hand, if the central bank lets inflation go, then it would be the real exchange rate that would have to appreciate. Either way, this would still be a “tragedy”.Javier Guillermo Gómez P.Researcher Banco de la RepúblicaThe views expressed in this comment are not necessarily those of the Banco de la República or its Board of Directors.ReferenceOcampo, José Antonio. “La macroeconomía de la bonanza económica”. Revista de la Cepal, No. 93, Diciembre de 2007, pp. 7-29.

  4. Guest   June 18, 2008 at 1:12 pm

    Hi, thanks for the text!Well, CC = I – SS= Y – C – Gin other words, a country will post current account deficits if it is investing too much or saving too little. Most of those countries could do a well better job reducing government spending and thus increasing S. Although, we should not be closed to the idea that there’s a huge gap in terms of infra-structure in those countries and that domestic supply will not be able to support awaking domestic consumption for a good deal of time. We need tighter fiscal policies and thus a better balance between fiscal and monetary policy – this is the only way interest rate differentials will be reduced and unsustainable sterilization of reserves building will stop – and financial flows will converge to a long-term rate.Latin America waisted the opportunity to perform real fiscal reforms during the bonanza years of 2002-2007, now it will be much tougher.Thanks a lot,Italo Lombardi

  5. Anonymous   October 20, 2008 at 3:50 pm

    this doesnt tell me ANYTHING!