Transcript Uruguay: Two Years of Monetary Policy in Adverse Conditions

Uruguay: Two Years of Monetary Policy in
Adverse Conditions
Comments by Víctor Olivo
The views expressed in this documents are those of the author and should not be interpreted as those of the Central
Bank of Venezuela.
Some similarities to the Venezuelan case
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This is a very interesting paper, particularly for an economist of
a central bank that faces similar problems in the design and
implementation of monetary policy to those discussed by
Dominioni for the case of Uruguay.
The Venezuelan economy has experienced a relatively high
(two - digits) and volatile inflation since the beginning of the 80s.
Most of the economic programs adopted in Venezuela to
stabilize the economy and curb inflation have been based on the
control of the exchange rate. The only exception was the
program applied during the period 1989 – 1991 under the
guidance of the IMF.
Some similarities to the Venezuelan case
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From 1996 to january 2002 the central bank adopted
an exchange rate band regime to control the inflation
rate which accelerated with the 1994 – 1995 finacial
crisis.
 The exchange rate band wich operated in practice as
a crawling peg regime achieved a gradual reduction
in infaltion (from 100% in 1996 down to 13% in 2001).
 However, the overvaluation of the currency, an
expansive fiscal policy, especially during 2000 and
2001, and political turmoil combined to make the
scheme unsustainable.
Some similarities to the Venezuelan case
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With the adoption of a floating exchange rate regime
the technical staff of the CB proposed to the
authorities a transition regime that we called Flexible
Monetary Strategy (FMS).
This FMS pretended to combine some elements of a
strategy based on the control of a monetary
aggregate (the monetary base) with those of an
inflation targeting regime by introducing an additional
set of indicators in the monetary policy decision
process.
Some similarities to the Venezuelan case
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The monetary aggregate target part of the FMS was
based on a band for the monetary base, with its
central value determined by the quantity theory and
the band limits defined to absorb demand / supply
shocks to the monetary base and accommodate an
inflation target set as range.
Unfortunately, the FMS failed:
– The monetary authorities never committed to the strategy
and continued their concern with the exchange rate,
intervening systematically in the FX market.
– Fiscal indiscipline and political instability intensifed in 2002.
Why the fascination with inflation targeting?
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I do not understand the fascination that Latin
American central banks show for inflation targeting.
Inflation targeting is a very vague strategy and
vagueness is a bad start for central banks that lack a
solid reputation as inflation fighters.
In the context of the models used by Ball (1997,
1998) it is easy to show that inflation targeting (either
strict or flexible) implicitly implies a Taylor type
interest rate rule (Olivo 2003).
Why the fascination with inflation targeting?
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Thus, interpreted as equivalent to following a Taylor
rule, inflation targeting would have the problem
pointed by Dominioni that it requires a well developed
financial market to be effective, but without the
transparency that the committment to an interest rate
rule would bring about.
Defined as a general framework for monetary policy
(not a rule) as it is done in Bernanke et al (1999),
Svensson (2000), and Mishkin and Savastano
(2001), we enter into a vagueness that gives little
guidance to policymakers about what to do to
achieve the inflation target. This approach is in its
core pure discretion (Bofinger 2001).
Why the fascination with inflation targeting?
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In a paper that I am working on (Interest rate rules Vs money
growth rules: some theoretical issues and an empirical
application for Venezuela), I compare the performance of an
interest rule, similar to the Taylor rule, with that of the money
growth rule proposed by Friedman (1962), and a flexible version
of this rule that responds to the inflation gap and the output gap.
Performance in this paper is measured in terms of the volatility
(unconditional variance) of the output gap and the inflation rate
when different shocks affect the economy under each type of
rule.
At the theoretical and empirical level, I find that the economy
(characterized by the output gap and the rate of inflation) should
behave in a fairly similar way when different shocks are
introduced under the diverse rules considered.
In general, the interest rate rule is better in terms of output
stabilization, while the money growth rules, particularly the
flexible version, is better in terms of inflation stabilization.
Why the fascination with inflation targeting?
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These results are in line with those in the empirical studies
conducted by Neumann and von Hagen (2002), and Ball and
Sheridan (2002), which find that different monetary strategies
achieved similar disinflationary results during the 90s.
What is the key then for the substantial improvement in the
effectiveness of monetary policy and central banks in the 90s in
terms of macroeconomic stabilization?
My answer is the the widespread change in focus toward price
stability in the long-run. In contrast to previous decades, central
banks in the 90s seriously committed to the attainment of price
stability as their overriding goal.
But despite the crucial role of committment to price stability in
the recent success of monetary policy, I still share Friedman´s
concern with the granting of too much discretion to monetary
authorities (Friedman, 1960, p. 86).
Why the fascination with inflation targeting?
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A more recent restatement of this argument is presented by
Woodford (2003), who considers that to lock in this success, it is
necessary to accompany it with a policy commitment.
“A systematic approach to policy provides an explicit framework for
decisionmaking within the bank, but that is also used to explain
the bank´s decisions to the public” (Woodford, 2003, p. 14)
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In contrast to Woodford, however, I believe that in less
advanced countries there is a strong case in favor of a monetary
policy based on a simple rule for a monetary aggregate.
The main reason is that with shallow financial markets and
shaky fiscal institutions, the link between the short-run interest
rate managed by the central bank and the long-run rate relevant
for aggregate demand decisions may be quite weak and
unstable.
Why the fascination with inflation targeting?
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A weaker recommendation would be that even if
monetary policy is conducted based on an interest
rate rule, monetary aggregates should still play a
major role in policy decisions. This view is strongly
supported by Poole (1994), Meltzer (2001), and is
embedded in the European Central Bank “two pillars”
strategy.
An assessment of the CBU strategy
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Given the prior considerations, I think that the CBU is on the
right track and it should not rush to join the IT club.
The CBU should stick to its strategy, and continue improving
operational aspects and transparency.
In this sense, announcing publicly an inflation target should
contribute to enhance the effectiveness of monetary policy, and
it is not contradictory with keeping the commitment to the
intermediate monetary base target.
My view is that the trick to a successful monetary policy (apart
from some luck) is to be persistent and keep a systematic
approach based on a clear commitment to price stability.
Inflation targeting and exchange rate
management: a word of caution
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In Olivo (Taylor Rules and Inflation Targeting Do Not Work with
Systematic Foreign Exchange Intervention, 2003), I used a
model similar to that developed by Ball (1998) to analyze how
the attempt to influence directly the behavior of the nominal
exchange rate affects the conduct of monetary policy under a
Taylor rule and inflation targeting.
The main conclusion of the paper is that a conflict exists
between the implementation of a Taylor rule or inflation
targeting, and systematic intervention in the FX market.
The response of the interest rate to given deviations of in output
and inflation from their mean levels is reduced under systematic
FX intervention.
Bibliography and References
Ball, Laurence, 1997. Efficient rules for monetary policy. NBER Working Paper 5952
1998. Policy Rules for Open Economies. NBER Working Paper 6760.
Ball, Laurence, Niamh Sheridan, 2003. Does inflation targeting matter? NBER Working Paper 9577.
Bofinger, Peter. 2001. Monetary Policy: Goals, Institutions, Strategies, and Instruments. Oxford University Press.
Friedman, Milton, 1962. A Program for Monetary Stability.
Nelson, Edward, 2002. Direct effects of base money on aggregate demand: theory and evidence. Journal of Monetary
Economics 49, 687-708.
McCallum, Bennett, 1999. Recent Developments in the Analysis of Monetary Policy. Federal Reserve of St. Louis Review,
November / December, Vo. 81, No. 6.
McCallum Bennett, Edward Nelson, 1999. An optimizing IS-LM specification for monetary policy and business cycle analysis.
NBER Working Paper 5875.
Meltzer, Allan, 2001. The transmission process. Published in The Monetary Transmission Process. Edited by the Deutsche
Bundesbank.
Mishkin, Frederic, Miguel Savastano, 2001. Monetary Policy Strategies for Latin America. Journal of Development
Economics Vol. 66, 415 – 444.
Olivo, Victor, 2003. Interest rate rules and inflation targeting do not work with systematic foreign exchange market
intervention. Banco Central de Venezuela, Serie Documentos de Trabajo, 41, March 2003.
2004. Interest rate rules Vs Money Growth Rules: Some Theoretical Issues and an Empirical Application for
Venezuela. Unpublished working paper.
Poole, William (1994). Monetary Aggregates Targeting in a Low – Inflation Economy. Published in Goals, Guidelines, and
Constraints Facing Monetary Policymakers; edited by Jeffrey Fuhrer. Federal Reserve Bank of Boston.
von Hagen, Jurgen, Manfred Neumann (2002). Does Inflation Targeting Matter? Federal Reserve Bank of St. Louis Review,
July / August, Vol. 84, No 4.
Walsh, Carl, 2003. Monetary Theory and Policy. Cambridge.
Woodford, Michael, 2003. Interest and Prices: Foundations of a Theory. Princeton University Press.