MONETARY POLICY IN MEXICO. Monetary Policy in Emerging Markets OECD and CCBS/Bank of England February 28, 2007

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1 MONETARY POLICY IN MEXICO Moneary Policy in Emerging Markes OECD and CCBS/Bank of England February 8, 7 Manuel Ramos-Francia Head of Economic Research

2 INDEX I. INTRODUCTION II. MONETARY POLICY STRATEGY III. MONETARY TRANSMISSION MECHANISM IV. MONETARY POLICY AND THE YIELD CURVE V. FINAL REMARKS

3 I. Inroducion CPI Inflaion (Percen) Source: Banco de México. Jan- Jan-7 Jan-7 Jan-74 Jan-76 Jan-78 Jan-8 Jan-8 Jan-84 Jan-86 Jan-88 Jan-9 Jan-9 Jan-94 Jan-96 Jan-98 Jan- Jan-4 Jan-6 Jan-98 Feb-988 Dec-994

4 I. Inroducion During he las years, Mexico has converged o a low, sable inflaion equilibrium. Essenial elemens: Fiscal conrol. Fiscal Responsibiliy Law. Cenral Bank (Consiuional) Auonomy. Floaing exchange rae. Financial secor reforms (e.g., capial accoun liberalizaion, pension reform, developmen of derivaives markes, ec). A favorable exernal environmen has also conribued: Benign inernaional financial condiions. Lower global inflaionary condiions. Solid economic growh. High oil prices.

5 CPI Inflaion and CPI Inflaion Targes (Percen) Annual CPI Inflaion 6 5 Inflaion Targe Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec- Dec- Dec- Dec- Dec-4 Dec-5 Dec-6 Oc-6 Jan-5 Apr-5 Jul-5 Oc-5 Jan-6 Apr-6 Jul-6 Jan-7 I. Inroducion Annual CPI Inflaion Inflaion Targe Source: Banco de México. 4% % %

6 INDEX I. INTRODUCTION II. MONETARY POLICY STRATEGY III. MONETARY TRANSMISSION MECHANISM IV. MONETARY POLICY AND THE YIELD CURVE V. FINAL REMARKS

7 II. Moneary Policy Sraegy Inflaion Iniial Siuaion Response o Inflaionary Pressures Disinflaion Program Long-run Targe Time 6

8 II. Moneary Policy Sraegy Lae 98 s and early 9 s: ERB sabilizaion and exernal deb renegoiaion. The reasons for he failure of ERB programs are well known (Tequila Crisis). Over he las years: ( ) Conainmen of inflaionary pressures from crisis. Reesablishing orderly marke condiions. ( ) Moneary policy becomes nominal anchor. Use of coro. (998- ) Gradual convergence owards inflaion argeing. By, fully fledged IT. 7

9 II. Moneary Policy Sraegy Over he las years, IT has become a mechanism o coordinae inflaion expecaions. 999 Medium-erm inflaion arge: inflaion similar o ha of major rading parners for. % CPI inflaion arge for. Formal adopion of IT. Long-erm inflaion arge: % (+/- percenage poin) from December onwards. Pre-announced daes for decisions. Does IT also help o disinflae? 8

10 II. Moneary Policy Sraegy Disinflaion ( low-frequency ). Use of a Non- borrowed Reserves Targe Coro. Numerous shocks o he exchange rae, ogeher wih a high pass-hrough. High exchange rae exposure (balance shee effecs). Wih high and volaile inflaion, difficul o deermine a suiable level for ineres raes. As inflaion and risk premia fall, markes deermine he speed a which ineres raes can be reduced. The use of he coro allowed he Cenral Bank o mainain a persisen resricive bias. 9

11 II. Moneary Policy Sraegy Nominal Ineres Rae (TIEE 8 days) and Coro (Percen and Daily Million Pesos) CPI Inflaion and Coro (Percen and Daily Million Pesos) Nominal Ineres Rae Coro (righ axis) Inflaion Coro (righ axis) Apr-95 Jun-96 Aug-97 Oc-98 Dec-99 Feb- Apr- Jun- Aug-4 Oc-5 Dec-6 Jan-95 Jul-96 Jan-98 Jul-99 Jan- Jul- Jan-4 Jul-5 Jan-7 Source: Banco de México.

12 II. Moneary Policy Sraegy Response o ( higher-frequency ) shocks. Among recen inflaionary shocks, he following sand ou:. Exernal cos-push shock a he end of 998 and he beginning of 999 (Eas Asian economies, Russia and Brazil crises).. Inernal demand shock during.. Inernal cos-push shock a he end of and he beginning of. 4. Cos-push shock (mainly exernal) during 4 (commodiies - e.g., energy and foodsuff prices). 5. Exernal cos-push shock (commodiy prices) exacerbaed by domesic disorions.

13 II. Moneary Policy Sraegy Response o ( higher frequency ) Inflaionary Pressures Inflaion Gap* (Percen) Nominal and Real Ex-ane Ineres Rae* (Percen) Real Ex-Ane Ineres Rae Nominal Ineres Rae Jan-98 Jan-99 Jan- Jan- Jan- Jan- Jan-4 Jan-5 Jan-6 Jan-7 Jan-98 Jan-99 Jan- Jan- Jan- Jan- Jan-4 Jan-5 Jan-6 Jan-7 * Shaded areas correspond o episodes of inflaionary pressures. The inflaion gap is he difference beween inflaion expecaions for he nex monhs and he inflaion arge. The laer is calculaed based on he annual inflaion arges announced by Banco de México. * Shaded areas correspond o episodes of inflaionary pressures.

14 INDEX I. INTRODUCTION II. MONETARY POLICY STRATEGY III. MONETARY TRANSMISSION MECHANISM IV. MONETARY POLICY AND THE YIELD CURVE V. FINAL REMARKS

15 III. Moneary Transmission Mechanism Low, sable inflaion has improved he funcioning of he nominal sysem, and hus, also of he real economy (e.g., runof-he-mill business cycles). Jan-8 Monhly Nominal Exchange Rae Depreciaion (Percen) Jan-8 Jan-86 Jan-89 Jan-9 Jan-95 Jan-98 Source: Banco de México. Jan- Jan-4 Jan-7 Inflaion Persisence, Sum of he Coefficiens from an AR() Model* (7 Monh Moving Average) Jan-96 Jan-98 Jan- Jan- Jan-4 Jan-6 * Corresponds o he sum of he coefficiens from an AR() process esimaed using a window for he previous 6 years Esimaed Specrum of he Monhly Percenage Change of CPI Shor Run Long Run 4

16 III. Moneary Transmission Mechanism Less Volaile Macroeconomic Aggregaes Gross Domesic Produc* (Peak=) Privae Consumpion* (Peak of GDP=) Gross Fixed Invesmen* (Peak of GDP=) * Seasonally Adjused Daa. Source: INEGI. 5

17 III. Moneary Transmission Mechanism These changes imply ha he ransmission mechanism of moneary policy has been changing in wo dimensions: Relaive imporance of he differen channels. Speed wih which he economy adjuss o shocks. To illusrae, a sandard small-scale macroeconomic model wih four srucural equaions is used: Equaions:. Phillips curve.is curve.rer 4.MP rule Samples: Shocks:. Ineres rae. Exchange rae. Cos-push 6

18 III. Moneary Transmission Mechanism Ineres Rae Shock of percenage poin in nominal ineres rae..4. Inflaion a (Percen). Oupu Gap b (Percen) Nominal Ineres Rae c (Percenage Poin). Real Ineres Rae d (Percenage Poin)

19 III. Moneary Transmission Mechanism ER Shock: percen depreciaion of he exchange rae..8 Inflaion a (Percen). Oupu Gap b (Percen) Nominal Ineres Rae c (Percenage Poin).8 Real Ineres Rae d (Percenage Poin)

20 III. Moneary Transmission Mechanism Cos-push Shock: percen increase in annual inflaion..4 Inflaion a (Percen) Oupu Gap b (Percen) Nominal Ineres Rae c (Percenage Poin). Real Ineres Rae d (Percenage Poin)

21 The previous exercises show: Low inflaion and he developmen of financial markes has eased credi consrains for households. Addiionally, households are able o beer smooh heir consumpion hrough ime. The imporance of he expecaions channel of moneary policy has increased in recen years. This has allowed he economy o beer adjus o shocks. III. Moneary Transmission Mechanism The reducion in he exchange rae pass-hrough makes he economy (e.g. inflaion and oupu) less vulnerable o exernal shocks. Moneary policy has become more effecive in reducing inflaion and such reducion can be aained wih a lower oupu cos.

22 INDEX I. INTRODUCTION II. CONDUCT OF MONETARY POLICY III. MONETARY TRANSMISSION MECHANISM IV. MONETARY POLICY AND THE YIELD CURVE V. FINAL REMARKS

23 IV. Moneary Policy and he Yield Curve As he macro environmen has become sable, financial markes have deepened. Simulaneously, moneary policy has become more effecive. These changes are refleced in a marked improvemen in he behavior of he yield curve. Analysis of he yield curve uses zero-coupon bonds and principal-componen mehodology. A sylized fac found in he lieraure is ha he firs principal componen can be associaed wih he level of he yield curve, while he second wih is slope (Lierman and Scheinkman, 99).

24 IV. Moneary Policy and he Yield Curve Nominal Ineres Raes (Percen) Overnigh Rae Year Year Jan- Apr- Jul- Oc- Jan- Apr- Jul- Oc- Jan-4 Apr-4 Jul-4 Oc-4 Jan-5 Apr-5 Jul-5 Oc-5 Jan-6 Apr-6 Jul-6 Oc-6 Jan-7 Source: Banco de México.

25 IV. Moneary Policy and he Yield Curve Level and Firs Principal Componen* Year- Day Slope and Second Principal Componen* Correlaion (PC, L) =.98 4 Correlaion (PC, S) = Componen (PC) Level (L) Componen (PC) Slope (S) -6-4 Jul- Jan- Jul- Jan- Jul- Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul- Jan- Jul- Jan- Jul- Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 * The level is compued as he average of -day, -year and -year yields. The level and firs componen are sandardized. 4

26 IV. Moneary Policy and he Yield Curve Overnigh Ineres Rae and Firs Principal Componen* Overnigh Ineres Rae and Second Principal Componen* 4 8 Correlaion (PC, OR) =.8 Correlaion (PC, OR) =.65 8 Correlaion (PC, OR) = -.54 Correlaion (PC, OR) = Componen (PC) Overnigh Rae (OR) Jul- Jan- Jul- Jan- Jul- Jan-4 Jul-4 Componen (PC) Overnigh Rae (OR) Jan-5 Jul-5 Jan-6 Jul-6 Jan Jul- Jan- Jul- Jan- Jul- Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 * The principal componen is sandardized. Ineres rae in percen. 5

27 IV. Moneary Policy and he Yield Curve Compensaion for Inflaion and Inflaion Risk Implici in year Bonds and Overnigh Rae* Compensaion for Inflaion and Inflaion Risk Implici in year Bonds and Firs Principal Componen* Correlaion (OR, C) = Correlaion (PC, C) = Overnigh Rae (OR) Compensaion (C) Componen (PC) Compensaion (C).5. Feb- Aug- Feb-4 Aug-4 Feb-5 Aug-5 Feb-6 Aug-6 Feb-7 Apr-4 Jul-4 Oc-4 Jan-5 Apr-5 Jul-5 Oc-5 Jan-6 Apr-6 Jul-6 Oc-6 Jan-7 * Compued using nominal and inflaion-indexed bonds. The principal componen is sandardized. Compensaion in percen. 6

28 IV. Moneary Policy and he Yield Curve Compensaion for Inflaion and Inflaion Risk Implici in year Bonds and Year- Day Slope* Correlaion (C, S) = Compensaion for Inflaion and Inflaion Risk Implici in year Bonds and Second Principal Componen* Correlaion (PC, C) = Feb- Aug- Feb-4 Slope (S) Compensaion (C) Aug-4 Feb-5 Aug-5 Feb-6 Aug-6 Feb Apr-4 Jul-4 Oc-4 Componen (PC) Compensaion (C) Jan-5 Apr-5 Jul-5 Oc-5 Jan-6 Apr-6 Jul-6 Oc-6 Jan * Compued using nominal and inflaion-indexed bonds. The principal componen is sandardized. Compensaion in percen. 7

29 INDEX I. INTRODUCTION II. CONDUCT OF MONETARY POLICY III. MONETARY TRANSMISSION MECHANISM IV. MONETARY POLICY AND THE YIELD CURVE V. FINAL REMARKS

30 V. Final Remarks Furher issues: Risk Managemen Domesic disorions Communicaion sraegy Changes in he exernal environmen 9

31 APPENDIX Small Scale Hybrid Macroeconomic Model

32 Small Scale Hybrid Macroeconomic Model ) ( ] [ 4 US e a x a E a a π π π π + Δ = + US q b x b r b x E b b x b x 5 4 ] [ = + )) ( ] [ ( US r r q E c c q q + + = + Phillips curve IS curve RER Moneary policy rule 4 * * 4 )] ( ) ( ) )[( ( = i d x d d d d d i π π π

Two ways to we learn the model

Two ways to we learn the model Two ways o we learn he model Graphical Inerface: Model Algebra: The equaion you used in your SPREADSHEET. Corresponding equaion in he MODEL. There are four core relaionships in he model: you have already