Latin American Corner: Thoughts on inflation targeting

By Naked Keynes (Guest Blogger)

Several Latin American economies (Brazil, Chile, Colombia, Mexico, Peru) adopted full-fledged inflation targeting regimes at the end of the 1990s and beginning of the 2000s. Others are following suit including the Costa Rica, Dominican Republic, Guatemala, Paraguay and more recently Argentina.

Inflation targeting is defined by its proponents as a monetary policy framework, rather than iron clad rule as monetary targeting, consisting in the public announcement of numerical targets (a point inflation rate, a range or a point with a tolerance range) acknowledging that price stability is the fundamental and hierarchical goal of monetary policy and a commitment to transparency and accountability. Transparency means that the monetary authorities must communicate their targets, forecasts of inflation, decisions on monetary policy and the motivation for their decisions. Accountability 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.” Full fledge inflation targeters practice ‘flexible’ inflation targeting entails pursuing a ‘gradualist’ approach to the achievement of monetary policy objectives.

The Latin American experience underscores some major limitations of inflation targeting. First, inflation targeting is not intended to reduce inflation and countries adopt inflation targeting regimes at very low inflation rates. The available empirical evidence shows that Latin American countries adopted full- fledged inflation targeting regimes at one-digit inflation rates. Latin America´s high inflation periods occurred in the 1970s and the 1980s. Inflation began to decline in the mid-1990s for the great majority of Latin American irrespective of their monetary and associated exchange rate regimes (Table 1).

Table 1:  Latin America: annual inflation rates (averages; 1960-2015) 

Country Name	1960-1971	1972-1983	1984-1995	1996-2007	2008-2015
Argentina	21	171	592	9	19
Bolivia	3	55	1,178	6	7
Brazil	44	62	928	9	8
Chile	31	170	18	6	4
Colombia	12	23	27	11	4
Costa Rica	2	27	18	11	7
Dominican Republic	2	8	29	12	5
Ecuador	10	11	0	4	5
El Salvador	1	9	5	3	2
Guatemala	1	10	18	6	5
Honduras	3	8	13	12	5
Mexico	4	30	51	11	4
Nicaragua	2	15	2,422	9	9
Panama	1	9	1	3	4
Paraguay	3	13	24	10	5
Peru	9	45	865	4	3
Uruguay	44	62	68	11	8
Venezuela, RB	3	14	34	33	27
Median	3	19	28	9	5
Standard Deviation	14	51	643	7	6

Source: On the basis of Word Bank development Indicators (2016)

Implementing inflation targeting regimes at a one-digit inflation rate level has an obvious theoretical justification: the condition for stability in an inflation targeting model is that the policy rate of interest in real terms must be positive (the nominal rate of interest has to exceed the future expected inflation rate). A two-digit inflation rate means that the Central Bank must adopt a two-digit monetary policy rate which in turn implies that the structure of interest rates must also conform to those levels.

There is here an important policy lesson for Argentina. The current authorities of the central bank of Argentina are committed to the adoption of inflation targeting. Since the rate of inflation is above 40% (the highest in more than a decade and half) this would also mean that the monetary policy rate must be set above the inflation level. With a structure of the terms of interest hovering above 40% do the Argentine authorities believe they can foster growth or are they trying to provoke a giant recession?

Second inflation targeting requires stable and certain economic conditions that can guarantee policy continuity but which are not present in the real world. According to its proponents, inflation targeting is about managing inflation expectations through public credible announcements in order to avoid abrupt changes in interest rates, output and employment. This is the main reason for ´flexible inflation targeting´ which implies continuous gradual changes in the monetary policy rate over time allowing agents to adapt their behavior to the existing monetary conditions. Thus, if the inflation rate is above target a tighter policy stance should translate into a continuous path of gradual interest rates increases over time until the rate of inflation converges to the target. Yet in many instances, the required conditions for policy continuity are simply not present because central banks can easily misread current conditions. As a result the aim for policy continuity turns in practice into a stop-and-go policy. This is what has happened in the last couple of years in Latin American inflation targeteres including Chile, Mexico and Peru.

Third the presumption that interest rates can manage both inflation and economic activity is wrong and in reality we often find is a disconnect, between interest rates, inflation and economic activity. Chile provides an interesting case of the disconnect between interest rates, inflation and economic activity: (i) inflation is currently at 5% annually above the target (3%) and the upper bound of the inflation target (4%); (ii) the monetary policy interest rate was negative in real terms during most of 2015 and after a 25% basis point increases the monetary policy rate is roughly zero in real terms; and (ii) the rate of growth has slowed down in the past two years to 2% from 5.5% and 4.% in 2012 and 2013.

Fourth so what is inflation targeting all about? Well, in some cases it is simply a policy to maintain the profitability of the financial system. Inflation targeting is portrayed as a very harmless policy: it is gradualist, it avoids giant costs in terms of employment, it promotes credibility and accountability, and it allows the full use of resources once the inflation target is met (this is known as the Divine Coincidence). Yet there is an aspect of inflation targeting which is harmful that is seldom mentioned and which has to with the relationship between the central bank and the financial system and which can be illustrated with the case of Latin America and more particularly with Chile. The Chilean Central Bank as a policy rate that is zero in real terms (and that was negative for almost a year). Commercial borrow from the Central Bank but commercial banks charge positive real rates of interest on their loans to consumers and businesses and pay nothing in real terms for their loans from the Central Bank.

Central Bank policy can easily become captive to the interests of the financial sector…So much for Central Bank independence.