From Tail Winds to Head Winds: Dilemmas and Trade offs for Monetary Policy in LAC Alain Ize Lima, June 16 2008 1
Aims and caveats Two aims: Summarize the current policy dilemma and ask broad questions on how to address it Provide a broad regional perspective of policy responses thus far, by monetary regime Two (main) caveats: No answers here (there are certainly no easy answers, but much less at this level of generality) Very broad brush overview has to be viewed with care (simple averages can be misleading) 2
Outline Assessing the shocks Demand or supply? Transitory or permanent? Formulating a response The response so far Tackling the exchange rate Better mañana?... Expanding the policy frontier 3
Demand or supply? 4
Demand pressures would certainly be expected in countries facing positive terms of trade shocks VEN TTO CHL PER BOL ECU COL LAC ARG MEX BRA JAM PAR SLV GT DR NIC HND PAN HTI CRI URY Terms of Trade for Selected LAC countries change between 2002 2006 in % 20 0 20 40 60 80 100 120 Source: World Bank staff (LCRCE) calculations, ECLAC and Haver Analitics. 5
But even for the other countries, strong demand pressures are also likely to be present The rise in commodity prices coincides (and largely results from) a booming world demand =>Non commodity exporters also benefit Lots of free capital roaming around for higher returns (even more so since the Fed s reduction in interest rates) =>Low real interest rate environment 6
LAC output growth is (at present) the highest it has been in decades 7% Cyclical adjusted Growth in Latin America and High Income Countries Trend growth computed using the band pass filter 6% High-Income Latin America 5% 4% 3% 2% 1% 0% 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 Source: WDI World Bank; National Authorities. Cyclical component of growth is computed using the band pass filter. 7
credit is booming 0.40 Latin America Credit Conditions Total Credit to the Private Sector annual growth of the private credit (in real local currency) 0.35 IT Dollarized Others 0.30 0.25 0.20 0.15 0.10 0.05 0.00 0.05 0.10 Mar 03 Sep 03 Mar 04 Sep 04 Mar 05 Sep 05 Mar 06 Sep 06 Mar 07 Sep 07 Mar 08 8
spurred by consumer lending 0.40 Latin American Credit Conditions Consumer Credit annual growth of the private credit (in real local currency) 0.35 IT Dollarized Others 0.30 0.25 0.20 0.15 0.10 0.05 0.00 0.05 0.10 Mar 03 Sep 03 Mar 04 Sep 04 Mar 05 Sep 05 Mar 06 Sep 06 Mar 07 Sep 07 Mar 08 9
and still very high asset prices, particularly for the IT countries 210 Stock Market Performance index 100=Jan06 190 IT Dollarized Others US 170 150 130 110 90 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 10
Transitory or permanent? 11
There are strong uncertainties about the world cycle Is the current inflation outburst due to a temporary squeeze in the world output gap? Is the cycle finally about to crash, courtesy of the US sub prime market? Or will there be an orderly restrain in world demand, allowing supply to catch up? Will there be a policy turnaround at the FED? Can China control its demand?... Or are the growth bottlenecks structural and unlikely to disappear any time soon? 12
Is it nominal or real?... Relative price adjustments cannot go on forever and can only have transitory impacts on inflation But what happens when both demand and supply elasticities for food and energy are very low? If accomodated, real adjustments can trigger runaway inflation as a way to reconcile conflicting ex ante claims (the old structuralist story ): Real wage rigidities (inflationary erosion of nominal wages) Consumption rigidities (inflationary erosion of budgetary appropriations for special food purchases or subsidies) 13
The response so far 14
What does the book say? Supply shocks require a different response than demand shocks: With nominal price rigidities for core goods, it would be too expensive to immediately try to offset non core inflation With real price and wage rigidities, stabilizing prices destabilizes output (there is a trade off no divine coincidence between output and inflation) Hence, unless you are an inflation nutter (strict IT) or there is a risk of second round effects (possibly undermining the nominal anchor), temporary deviations from target due to pure supply shocks are ok But watch for: Shifts in longer term inflationary expectations Pass through of non core to core inflation (wages) 15
Indeed, many inflation targeters (or near targeters) have so far overshot their target Inflation Target and Actual Inflation for Selected LAC countries as of December 2007 in % YoY 10 Upper Bound of the Inflation Target Actual Inflation 8.76 8.87 8.1 8 6 6.5 6.35 6 6 4 4.61 4 4.5 4 3.72 4.82 4 4.9 3 2 0 BRA CHL COL MEX PER GTM SLV HND 16
as consumer prices inflation has started rising since the first semester of 2007 16% Latin American Consumer Prices Inflation annual variations, simple average by monetary regime 14% IT Dollarized Others 12% 10% 8% 6% 4% 2% 0% Jan06 May06 Sep06 Jan07 May07 Sep07 Jan08 17
While food inflation is clearly in the lead, non food inflation also started rising towards end 2007 12% 10% ITs Consumer Prices Inflation annual variations IT non food IT food 14% 12% Dollarized Consumer Prices Inflation annual variations Dollarized non food Dollarized food 25% 20% Others Consumer Prices Inflation annual variations Others non food Others food 8% 10% 8% 15% 6% 6% 10% 4% 4% 2% 2% 5% 0% Jan06 May06 Sep06 Jan07 May07 Sep07 Jan08 0% Jan06 May06 Sep06 Jan07 May07 Sep07 Jan08 0% Jan06 May06 Sep06 Jan07 May07 Sep07 Jan08 18
but has been somewhat more subdued in the IT countries 10% 9% 8% Latin American Non Food Prices Inflation annual variations, simple average by monetary regime IT Dollarized Others 7% 6% 5% 4% 3% 2% 1% 0% Jan 06 Mar 06 May 06 Jul 06 Sep 06 Nov 06 Jan 07 Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 19
as the wage response seems to have been thus far rather restrained 25% Workers Wages Indexes for Selected LAC countries annual variation rates 20% 15% ARG BRA COL ECU MEX 10% 5% 0% Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 20
notwithstanding the high increases in food prices 25% 20% IT Dollarized Others Latin American Food Prices Inflation annual variations, simple average by monetary regime 15% 10% 5% 0% Jan 06 Mar 06 May 06 Jul 06 Sep 06 Nov 06 Jan 07 Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 21
perhaps partly reflecting the differential impacts of food prices on headline inflation 0.36 Weight of Food on the CPI basket simple average by monetary regime 0.34 0.32 0.30 0.28 0.26 0.24 0.22 0.20 ITs Dollarized Others 22
The price response seems to have reflected the monetary response, itself a function of the monetary regime Monetary Policy Rates average rate by monetary regime 10 9 8 IT Dollarized Others US 7 6 5 4 3 2 1 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 23
that in turn triggered substantially different real interest rate responses (although all are falling) 6 Real Interest Rate Nominal interest rates CDs deflacted by CPI, in % 4 2 0 Jan 06 Mar 06 May 06 Jul 06 Sep 06 Nov 06 Jan 07 Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 2 4 6 IT Dollarized Others 8 24
The decline in growth adjusted real rates is even more dramatic 25 Real Interest Rate adjusted by Growth Nominal interest rates on CDs deflated by CPI and GDP growth, in % 20 IT Dollarized Others 15 10 5 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 5 10 25
The scope for a stronger response, particularly in the IT countries, has bumped into the carry trade business Returns of the Carry Trade for Selected LAC countries annual ex post returns 3M moving averages 80% 70% 60% 50% 40% 30% 20% 10% Brazil Peru Chile Colombia 0% Jan 07 10% Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 20% 30% Elaborated by the LCRCE World Bank. Datasource: Bloomberg & National Authorities. 26
and the concern for nominal appreciation Nominal Exchange Rate vís a vís with the US dollar. Index: 100=Jan2003 120 110 IT Dollarized Others 100 90 80 70 60 2000 2001 2002 2003 2004 2005 2006 2007 2008 27
that resulted in strong real appreciations 125 Real Effective Exchange Rate Index: 100=Jan2002 bís a bís the US dollar 120 IT Dollarized Others 115 110 105 100 95 90 2002 2003 2004 2005 2006 2007 2008 Source: IFS IMF, Real Effective Exchange Rate. 28
although some of the appreciation could well reflect equilibrium adjustments 110 Real Effective Exchange Rate Index, 100=Jan2003 105 100 d(tot)>0 d(tot)<0 95 90 85 80 75 70 2001 2002 2003 2004 2005 2006 2007 2008 29
Tackling the exchange rate 30
Exchange rate adjustments are likely to play an increasingly important role in IT countries Financial globalization is increasingly limiting the scope for deviations from UIP Yet, at the same time, IT has led to lower exchange rate passthroughs More (real) exchange rate volatility Less direct impact on inflation from a real appreciation 31
Is this a problem? The conventional view Monetary policy cannot have sustained effects on anything else than inflation Real exchange rates (both in the short run and the long run) are strictly endogenous Real appreciations (hence adjustments in the tradable sector), as painful as they may be, are unavoidable for countries facing positive terms of trade shocks Targeting the exchange rate has the same drawbacks as targeting asset prices (it can only muddle the waters) Hence, only worry about exchange rates if they affect prices and the output gap However, to play safe: Target expected inflation and expected output Target domestic prices rather than the CPI 32
An alternative view The conventional IT paradigm is flawed because it is based on a single sector aggregate short term model: Two sector models (tradable/nontradable) highlight the higher potential output costs (in the tradable sector) of real appreciations There may be dynamic costs associated with (temporary) real appreciations (investment irreversibility; growth linkages a la Rodrick) =>This would suggest limiting exchange rate volatility, hence a more cautious/gradual approach at taming inflationary pressures On the other hand, focusing on domestic inflation only could also be dangerous: with real (wage) rigidities, it might be better to kill inflationary dynamics in the bud 33
Thus far, the appreciations do not seem to have been too detrimental to exports 50 40 BRA CHL COL PER MEX Manufacture Exports from LAC Selected countries annual growth rates, in % 30 20 10 0 10 20 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Jan07 Jul07 Jan08 34
Better mañana? 35
Delaying the response has potential benefits Playing for time can: Help clear up some of the uncertainty about the world environment and limit the extent of policy asynchronism (hence the potential for exchange rate overshooting) 36
but also clear risks Inflationary expectations could end up unraveling if: Short term deviations from a simple policy rule are interpreted as a sign of a weak long term commitment to stable prices Real income rigidities are systematically accomodated => Is the sacrifice ratio tomorrow going to be even steeper than today? => Is this the moment of truth for IT in LAC countries: can it deliver more than exchange rate targeting? 37
Expanding the policy frontier 38
Could the effectiveness and flexibility of IT be improved through operational adjustments Possible adjustments include: Changing the nature of the inflation target Broadening or raising the inflation target Lengthening the targeting horizon Explicitly incorporating other targets (output, changes in real exchange rates, etc.) in the central bank s policy objectives Better communication and transparency (changes in content or strategy) Is it the right time for fiddling around with the IT scheme?... => Next presentation 39
Traditional attempts to escape the impossible trinity do not seem to have much rope left The effectiveness of exchange market intervention appears to be questionable when monetary policy needs tightening (Colombia?) Throwing sand in the wheels runs against the logic of increasing financial sophistication and globalization Price controls discourage supply and run into fiscal constraints 40
On the other hand, some targeted financial sector measures might help Encouraging capital outflows (institutional investors) Encouraging the development of exchange rate hedges Raising private domestic savings?... 41
A more countercyclical fiscal balance might also help raise domestic savings 2.0% Structural Fiscal Balance* For LAC 7, as % of GDP 1.0% Observed Balance Structural Balance 0.0% -1.0% -2.0% -3.0% -4.0% -5.0% Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Source: IDB. *A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), If Latin America were Chile: A Comment on Structural Fiscal Balances and Public Debt 42
And what about prudential policies? In view of the credit booms, are stronger measures to moderate credit growth (provisioning or capital requirements, liquidity requirements, etc.) called for? 43
some of this seems to have already occurred in the IT countries 450 400 350 Assets: Reserves Assets: Credit to Priv. Liabilities: Deposits Monet. Autho.: Intern. Reserv. (USD) Selected Monetary Aggregates of ITs index, 100=2000Q1 300 250 200 150 100 50 Mar00 Sep00 Mar01 Sep01 Mar02 Sep02 Mar03 Sep03 Mar04 Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 44
and the dollarized countries 350 300 Assets: Reserves Assets: Credit to Priv. Liabilities: Deposits Monet. Autho.: Intern. Reserv. (USD) Selected Monetary Aggregates of Dollarized index, 100=2000Q1 250 200 150 100 50 Mar00 Sep00 Mar01 Sep01 Mar02 Sep02 Mar03 Sep03 Mar04 Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 45
but perhaps not so for the other countries 650 550 Assets: Reserves Assets: Credit to Priv. Liabilities: Deposits Monet. Autho.: Intern. Reserv. (USD) Selected Monetary Aggregates of Others index, 100=2000Q1 450 350 250 150 50 Mar00 Sep00 Mar01 Sep01 Mar02 Sep02 Mar03 Sep03 Mar04 Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 46
From Tail Winds to Head Winds: Dilemmas and Trade offs for Monetary Policy in LAC Alain Ize Lima, June 16 2008 47