[Viewpoint] Inflation targeting - plus!

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, 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.

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 U.S. economy sneezed, Latin America’s economies caught pneumonia. This time, the U.S. 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.

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.

*Copyright: Project Syndicate, 2012.
The author is a visiting professor at Columbia University for 2011-2012.

By Andres Velasco