WEATHERING THE GLOBAL STORM : THE BENEFITS OF MONETARY POLICY REFORM IN THE LA5 COUNTRIES / IMF WORKING PAPER ( HIGHLY RECOMMENDED READING )

IMF Working Paper

Weathering the Global Storm: The Benefits of Monetary Policy Reform in the LA5 Countries

Prepared by Jorge Iván Canales-Kriljenko, Luis I. Jácome H.,Ali Alichi, and Ivan Luís de Oliveira Lima

December 2010-
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I. INTRODUCTION

Countries in Latin America know from experience the cost of macroeconomic and financial instability. Many have gone through recurrent crises that took a large toll on economic growth and fueled social unrest. These crises were often triggered by exogenous shocks, which unveiled macroeconomic and/or financial vulnerabilities, often leading to simultaneous banking and currency collapses. The crises caused social frustration, as vast groups of the population lost their jobs, real income, and savings.


Since the late 1990s, many Latin American countries have substantially improved their macroeconomic and financial policies. Improved macroeconomic policies resulted in larger international reserves, lower external debt, and better public debt profiles. Latin American countries have also strengthened their regulatory and supervisory frameworks and thus reduced vulnerabilities in domestic financial institutions.


Many Latin American countries also adopted far-reaching structural reforms, including the approval of new central bank laws. The new legislation increased the autonomy of central banks and focused their mandate in preserving price stability. In return, central banks were held accountable for the enhanced delegated authority they received and directly in relation to their policy targets.


Based on these institutional foundations, a few Latin American countries were among the pioneers in significantly improving their monetary policy frameworks by adopting an inflation targeting framework. In particular, Brazil, Chile, Colombia, Mexico, and Peru (the LA5 countries) adopted inflation targeting (IT) between 1999 and 2002. This framework provided flexibility to monetary policy and became an alternative to exchange rate management or the use of traditional money targeting as a nominal anchor.


With stronger institutional underpinnings and with the support of their IT framework, the LA5 central banks built up credibility on the conduct of monetary policy. In a region battered by decades of very high inflation—Brazil and Peru had posted four-digit rates in the early 1990s—the LA5 central banks managed to anchor inflation expectations during the current decade. As a result, they gained credibility as institutions committed with the objective of price stability.


A credible monetary policy, with the support of stronger macroeconomic and financial foundations, enabled the LA5 to manage successfully significant stress during the recent global crisis. Thanks to the flexibility of the IT frameworks, central banks reacted quickly and decisively to cope with the effects of the surge in commodities and food prices

worldwide in 2007-2008 and subsequently with the impact of the financial crisis in the industrial world.


See Kaminsky and Reinhart (1998 and 1999), which includes, in the sample, several Latin American crises from the 1980s to mid-1990s, and Jácome (2008) for financial crises that occurred from the mid-1990s onward.


This paper highlights the major elements of central bank reform in the LA5 countries and the benefits of monetary policy credibility, in particular in the wake of the recent adverse external environment. The experience of LA5 central banks can be useful for countries seeking to enhance monetary policy effectiveness and to be better prepared to cope with recurrent external shocks.

The paper is structured as follows: Section II briefly describes the reforms adopted by the LA5 central banks, including in the institutional, policy, and operational areas. Section III documents how LA5 central banks used the enhanced monetary policy flexibility to respond to the inflationary pressure arising from high food and fuel prices and later to sudden capital outflows and the deflationary pressures arising from the global financial crisis. Section IV reflects on the Latin American experience and the literature at large to provide key recommendations and suggestions for other central banks that aim to boost monetary policy effectiveness.

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