[R-G] The Tragedy of Current Latin American Monetary Policy

[Yoshie Furuhashi]

<http://www.rgemonitor.com/latam-monitor/252533/the_tragedy_of_current_latin_american_monetary_policy>
The Tragedy of Current Latin American Monetary Policy
Jose Antonio Ocampo | May 1, 2008

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).

<http://media.rgemonitor.com/images/blogs/image004_24.gif>

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?