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Latin America's Monetary-Policy Test

01-04 15:05 Caijing

2012 will be a crucial time of trial for central banks throughout Latin America.

By Andrés Velasco

SANTIAGO – On matters of sex, the citizens of mostly Roman Catholic Latin America often proclaim one thing and practice something very different. On matters of monetary policy, Latin central banks often also fail to live up to what they preach.

In theory, monetary authorities in Brazil, Chile, Colombia, Mexico, Peru, and Uruguay adhere to the modern orthodoxy of inflation targeting, which holds that price stability is the main (perhaps the only) goal of monetary policy, the short-term interest rate should be the only instrument used to achieve the inflation target, and the exchange rate ought to float freely.

But the actual practice of all six central banks bears only a passing resemblance to this orthodoxy. To begin with – and not surprisingly for export-led economies – the real exchange rate is also an (implicit) target for monetary policy. As a result, interventions in foreign-exchange markets have been lasting and widespread, even in countries like Chile and Mexico, which explicitly vowed to let their currencies float freely. Some countries – most notably Brazil – have also used taxes on international capital flows and other kinds of controls in an effort to guide the currency’s value.

The deviations from standard inflation targeting do not stop there. Colombia, Peru, Brazil, and other countries in the group have also used a range of unconventional policy tools – especially changes in reserve requirements for bank liabilities of varying maturities and currency denominations – to manage liquidity and credit.

Unconventional monetary policy was most evident during the crisis. After all, if the supposedly orthodox chairman of the United States Federal Reserve Board, Ben Bernanke, was wisely throwing orthodoxy to the winds, why shouldn’t Latin American central bankers do the same? But such policies have since become part of their toolkit in more normal times. Brazil, for example, has recently lowered reserve and capital requirements in an effort to stimulate the economy after a slow 2011.

What is emerging is not an alternative paradigm, but rather an expanded, richer, and more flexible version of inflation targeting. And, if one is to judge by these six Latin American economies’ performance since the 2008-2009 shock, the record of “inflation targeting-plus” so far is encouraging. Historically, whenever the US economy sneezed, Latin America’s economies caught pneumonia. This time around, the US became (and remains) very ill, yet Latin America barely sneezed. After mild and relatively short-lived recessions in 2009, the region’s economies recovered strongly in 2010.

Some of the credit should go to the new monetary-policy framework, which allowed central banks to create domestic liquidity quickly after international financing suddenly dried up. But a much-improved fiscal framework also helped – in countries like Chile and Brazil, fiscal policy could afford to become strongly counter-cyclical – and so did the rapid recovery in commodity prices in 2010.

In other dimensions, the record is mixed. It is not obvious that the various currency market interventions had a big effect on Latin American exchange rates. But as a result of these policies, every country in the group is starting 2012 with larger international reserves and foreign debts with longer maturities than they would have had otherwise.

That is the right news at the right time, because 2012 will be a crucial time of trial for central banks throughout Latin America. The impending collapse in Europe, the global drop in risk appetite, and slower world trade are already having an impact on the region’s economies. Exports are weakening, domestic credit is slowing, and asset prices are showing worrying volatility.

In response, monetary authorities have signaled not just that they will cut rates, but also that they will use an array of unconventional measures to prop up growth. That is, central bankers are beginning to preach what they practice. Who knows, maybe private citizens will be next.

Andrés Velasco, a former finance minister of Chile, is a visiting professor at Columbia University for 2011-2012.


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