Vittorio Corbo: Monetary policy in emerging countries - the view from Chile
Speech by Mr Vittorio Corbo, Governor of the Central Bank of Chile, at the Bank of Italy, Rome,
18 June 2007.
Prepared for presentation at Banca d'Italia. I thank Marcelo Ochoa and Ivonne Vera for assistance and Klaus Schmidt-Hebbel
and Andrea Tokman for suggestions and comments.
* * *
Emerging economies have recorded major progress in the conduct and results of monetary policy
during the last two decades. This achievement is due to implementation of more robust and
transparent monetary regimes, complemented by adoption of flexible exchange rates, sustainable
fiscal policies, and stronger financial systems. Among emerging economies, Chile's experience is of
particular interest. It shows that monetary stability can be attained as a result of coherent policies,
overcoming decades of macroeconomic instability and weak credibility.
This presentation documents the improvement of monetary policy conduct and results in emerging
economies in general and Chile in particular. Section 1 summarizes the overall trend and specific
components of macroeconomic adjustment observed in emerging economies. Chile's transition toward
its current monetary policy framework, based on full-fledged inflation targeting, is described next.
Section 3 analyzes and documents the results of improved monetary policy in emerging economies
and in Chile during the last two decades. Brief conclusions close the presentation.
1. Macroeconomic adjustment in emerging economies
Macroeconomic management in emerging markets has improved substantially in the last decade. In
particular, the very favorable world economic conditions that have resulted in important terms of trade
gains have been associated this time to fiscal prudence, complementing monetary and exchange-rate
policies aimed at achieving and maintaining price stability.
Four areas of macroeconomic adjustment: Fiscal, monetary and exchange rate policies, and
the financial system
The main changes that have taken place are in four key areas: (i) adoption of sustainable and
responsible fiscal policies, reflected in declining fiscal deficits in most emerging economies (figure 1);
(ii) adoption of floating regimes or hard pegs, moving away from intermediate exchange-rate (ER)
regimes; (iii) shift of monetary policy (MP) anchors from ERs or monetary aggregates to an
inflationtargeting (IT) anchor, particularly in Latin America; and (iv) these changes have been accompanied by
the strengthening of regulation and supervision of financial systems, supporting strong financial
development.
Shift toward more flexible ER regimes
The world shift toward more flexible ER regimes has been pronounced. The evidence shows a
significant shift away from intermediate regimes. In 1990, nearly 70% of all countries were pursuing
some variant of intermediate ER regimes, a share that dropped to 41% by the end of the 1990s, and
further to 30% in 2004 (figure 2)1.
Exits from intermediate regimes were more frequently towards floats rather than to hard pegs. The
share of floaters increased from 15% in 1990 to 45% in 2004 while, on the other extreme, the share of
hard pegs rose from 15% to 26% during the same time span. The latter increase in hard pegs reflects,
to some extent, the establishment of the European Monetary Union in 1999. The share of countries
with crawling pegs - a very popular regime among higher-inflation economies - dropped from 14% in
1990 to 6% in 2001. In contrast, countries with a crawling band or a tightly managed float rose from
10% at the beginning of the 1990s to 31% by the year 2001. Crawling bands offer - at least in the
short-term - more flexibility in coping with volatile capital flows and avoiding extreme ER
misalignments, than rigid ER regimes. Tightly managed floats, on the other hand, keep the anchoring
role of the exchange rate without committing to any explicit target parity.
The transition of ER regimes has come with a shift of MP regimes based on an ER or
monetarygrowth anchor to an IT framework, particularly in emerging economies. The number of countries under
IT rose from 8 in 1999 to 21 in 2004 (tables 1-2), and many more are considering to adopt IT in the
near future. This transition in MP regime has been more pronounced in Latin America. While in 1994
twelve countries in the region had in place an ER anchor, and four others had a monetary growth
anchor, by 2004 only three countries remained with an ER anchor. The transition of policy frameworks
during 1994-2004 led to a significant rise in the number of Latin American countries with a floating
regime (from three to twelve countries) and an inflation targeting framework (from one to five
countries).
2. Chile's transition to its current monetary policy framework
The macroeconomic institutional and policy framework of Chile has been transformed radically in the
last 25 years, from one that made stabilization an exceptional result to one that has facilitated
achieving price stability.
Chile's current macroeconomic framework is based on four pillars: (i) an autonomous Central Bank
with the explicit mandate of safeguarding stability of prices and payments; (ii) a low public-debt to GDP
ratio and a fiscal policy rule anchored to a structural fiscal surplus; (iii) a robust financial system, with a
dynamic, competitive, and well capitalized banking industry, appropriately regulated and supervised;
and (iv) a full-fledged inflation targeting monetary framework, complemented by a floating ER regime.
Substantial progress was made in CBC autonomy since the 1980s, when autonomy was very weak,
even at lower levels than in the average emerging economy. The granting of legal independence in
1989 through constitutional law, led to a much improved position in the international ranking of central
bank autonomy. Particularly economic independence of central banks - the freedom of taking policy
decisions independently of political interference - places Chile well above the average level of
independence of both emerging and developed economies in 2003.
Chile has shown a responsible fiscal policy, which has contributed significantly to successful monetary
policy. During the 1990s, the fiscal balance averaged a surplus of 1.5% of GDP. The above-mentioned
structural fiscal surplus rule stabilizes government spending over time, by linking it explicitly to
permanent government revenue. Therefore fiscal dominance of monetary policy is ruled out in Chile,
as a result of central bank autonomy and Chile's sound fiscal policy.
Public debt has shown a substantial decline since the 1990s, as a result of prudent fiscal policy. The
share of consolidated gross public debt has been reduced from 76% of GDP in 1990 to 20% of GDP in
2006, whereas the consolidated net public debt position turned from 34% of GDP in 1990 to -6% in
2006 (figure 3). The successful performance of the fiscal position has been enhanced by the fiscal
balance rule applied since 2001 (figure 4).
Chile's good growth performance, complemented by a market-based incentive structure, appropriate
regulation and sound supervision of the financial system, has resulted in a safe and sound financial
system and deep capital markets.
As a result of the major banking crisis that came with the deep 1982-1983 recession, the 1986
Banking Law enhanced regulation and supervision of the financial system. Since then, the financial
system has developed around a well-managed and capitalized banking sector that is both healthy and
competitive. This feature also rules out financial dominance of monetary policy in Chile. The CBC
shares normative attributions with a specialized public institution, focusing on the formulation of
financial regulations applicable to monetary markets.
Chile's financial system strength has been acclaimed by international credit rating agencies. Moody's
Financial Strength Ranking
places Chile's financial strength close to the top of industrial countries
(figure 5).
Monetary policy framework: Central Bank charter and its objectives
Although the road to CBC autonomy began in the mid-1970s, the 1989 Constitutional Law of the CBC
specified the Bank's objectives and granted CBC the necessary instruments to comply with its legal
mandate. Since 1989, the CBC is an autonomous, technical institution, governed by the Constitution,
with full legal capacity, control of its equity, and of indefinite duration.
The constitutional law establishes two objectives for the CBC. The first objective is to preserve the
stability of Chile's currency. This means avoiding loss of purchasing power due to inflation. The latter
objective is achieved through ensuring that inflation remains low and stable. The second objective of
the CBC is to ensure the normal functioning of domestic and external payments, by safeguarding the
financial sector's primary functions of credit and savings intermediation, provision of payment services,
and proper risk allocation by financial markets.
CBC's Constitutional Law prohibits CBC credit to the government. In order to contribute to policy
coordination and information sharing, and minimizing potential conflict between fiscal and monetary
authorities as a consequence of CBC autonomy, the Constitutional Law mandates participation of the
Finance Minister at monetary policy meetings, without voting rights but with the temporary right of
suspending a Board decision. Furthermore, the Law states that CBC policy decisions must take into
account the government's general economic policy orientation.
Overview of the evolution of MP framework
The Chilean experience with IT can be split into two periods. The first one - from 1991 to 1999 - falls
short in many aspects of a full-fledged inflation targeting framework. This first phase featured more
than one anchor (an ER band, in addition to the inflation target) and low levels of MP transparency
and communication. The second phase - from 2000 to the present - features a single inflation target
and an active communication strategy for MP.
In the context of reporting the annual monetary program to the Congress, the CBC announcement of
an annual inflation target arose as a natural response to the legal mandate for price-level stability. In
1991, the first official target - at a 15%-20% annual target range - was publicly announced in
September 1990 for the Dec. 1990-Dec. 1991 rate of annual CPI inflation. From 1990 to 1996, targets
were set annually as target ranges in September for the subsequent calendar year, and from 1997 to
1999 as target points (figure 6). Between 1991 and 2001, annual targets were lowered by 1.5
percentage points per year on average.
Inflation performance improved considerably during this period, achieving a reduction from 20%-30%
annually to low single-digit rates. However, independence and effectiveness of the MP were hindered
by conflicts between the exchange-rate-band, annual inflation targets, and capital controls.
Transition to a full-fledged IT framework was implemented when inflation was converging to 3%,
monetary policy was strengthened by attainment of inflation targets, the ER band was replaced by a
floating ER regime, and capital controls were fully abolished.
From 2000 to 2006, the target was defined for annual CPI inflation at a range of 2% to 4%, and the
monetary policy horizon was defined as 12 to 24 months. Since 2007, the MP objective is to keep
annual CPI inflation rate most of the time at around 3%, within a symmetric tolerance range of one
percentage point, focused on a policy horizon of around two years. This target redefinition strengthens
the 3% level as the nominal anchor of the economy, while recognizing that inflation can temporarily
deviate from the 3+/-1% range to accommodate transitory shocks. In parallel, the horizon for monetary
policy was extended to around two years. The latter changes were largely an explicit acknowledgment
of how monetary policy had been conducted during preceding years.
Transparency and communication
In the last decade, central banks around the world have significantly improved their communication
with the public and the markets. This provides institutional legitimacy and substantive accountability.
More transparency and better communication also improve MP effectiveness, contributing to a better
understanding of MP by the private sector. MP affects spending decisions, output, and prices more
through its effects on market expectations on the future course of monetary policy, rather than through
the direct effects of a change in the short-term MPR.
Since 2000 the CBC has made a large effort to deliver more and better information to the markets and
to explain how its IT regime operates. A series of communication devices were developed, including
disclosure of relevant data with a minimum time lag and making information available on the CBC
website, a significant number of technical publications, including the Monetary Policy Report (with a
four-monthly frequency, since May 2000); the Financial Stability Report (semi-annual, since 2004); the
Monetary Policy Framework
document (updated in January 2007, previous in May 2000), and
Projection Models book (since 2003). The CBC publishes monthly MP meeting dates six months in
advance (since 2000), the summary of MP minutes with the Board members' voting decisions (since
2000), and background information on MP minutes (since July 2005). The time lag for the release of
the minutes was lowered first from 90 to 45 days, and then to five days before the next monthly MP
meeting.
3. Monetary policy results in emerging economies and in Chile
Convergence of inflation to developed-country levels
There are several empirical studies exploring how emerging economies in general, and Chile in
particular, have benefited from implementation of an IT regime. The evidence shows that IT has been
very helpful in bringing inflation down to low single-digit levels in emerging economies. It has been
shown that the adoption of IT has played a leading role in emerging economies' successful
convergence to inflation levels observed in developed economies (Mishkin and Schmidt-Hebbel,
2007).
Small deviations of inflation from target in Chile
It has been shown also that IT countries are more successful in attaining their inflation targets than
non-IT countries (Mishkin and Schmidt-Hebbel, 2007). The introduction of IT has also helped Chile to
attain levels of inflation closer to target levels. Albagli and Schmidt-Hebbel (2004) provide an
international comparison of inflation performance and deviations from targets for 21 IT countries. They
consider the average relative deviation of inflation from targets since the beginning of IT in each
country. The results show that Chile is the second most accurate IT country in hitting its inflation target
(figure 7).
Since adoption of full-fledged IT by Chile in 2000, average annual inflation has been 2.9%, remaining
around 75% of the time within the target range. Only 10% of the time did inflation rate rise above the
upper target bound, and 15% of the time inflation fell below the lower bound (figure 8).
Inflation targeting and credibility
Adoption of IT has also contributed to the buildup of credibility of monetary policy in IT countries.
Several authors show that the IT regime has helped in anchoring inflation expectations at levels close
to inflation targets and inflation expectations are more stable than in the U.S. (Ramos et al., 2007;
Gürkaynak et al., 2007).
In Chile, the distance of inflation expectations from inflation targets was closed as targets converged
toward the stationary 3% level and the Central Bank showed strong commitment to attaining targets
(Céspedes and Soto, 2005). During the past five years, inflation expectations have remained close to
the mid-point of the inflation target range, reflecting high credibility of the IT regime (figure 9).
Inflation targets and stability
Emerging economies have experienced reductions in the volatility of both inflation and output (figure
10). However, volatility reductions have been more pronounced in IT countries than in non-IT
countries. Volatilities of growth and inflation have fallen very significantly in Chile, even in comparison
to other IT countries.
Two factors explain most of the volatility reduction in IT countries: smaller shocks hitting the economy
and improvements in monetary policy efficiency (Mishkin and Schmidt-Hebbel, 2007).
Figure 11 depicts the estimated average efficiency frontier of MP for emerging economies before their
adoption of IT (orange schedule) and the observed pair of output and inflation volatilities (red point).
The figure also depicts the estimated average efficiency frontier of MP for emerging economies after
IT adoption, for the period of stationary inflation targets (blue line) and the observed pair of output and
inflation volatilities (green dot). On one hand, the shift of the efficiency frontier toward the origin
reflects the smaller shocks faced by emerging economies since they have had stationary IT in place.
On the other hand, the observed combination of output and inflation volatilities has moved closer to
the efficiency frontier, revealing the corresponding improvement in monetary policy efficiency. In this
case, the smaller shocks explain 58% of the current performance, while the improvements in monetary
policy explain 42% of the decline in volatilities.
Chile also records massive improvements in monetary policy management. Not only does Chile face
smaller shocks, as reflected by the inward shift of the MP efficiency frontier, but also MP efficiency has
improved significantly, as reflected by the closer position of observed volatilities to the efficiency
frontier (see figure 12).
Contribution of central bank policy to macroeconomic stability
Emerging economies have improved MP practices. However, the contribution of monetary policy to
macroeconomic performance still is low. The annual Report on Competitiveness prepared by the
Institute for Management Development (IMD) shows that the positions of emerging economies in the
country ranking of the contribution of central bank policy to development has not changed significantly
since 1998.
However, Chile has recorded major improvements during the past decade. In 1998, the CBC was
ranked 25 among 60 countries, while reaching the first place in the world ranking in 2004, holding this
place in the subsequent years (figures 13-14).
4. Conclusions
Macroeconomic conditions have improved significantly in emerging economies since the early 1990s.
Emerging economies show major progress in fiscal responsibility and sustainability; adoption of a
framework of central bank autonomy, monetary regimes based on IT, and larger exchange-rate
flexibility; and achievement of financial system strength.
Adoption of more flexible exchange rates and an IT regime has contributed to lower output and
inflation volatility, and stronger credibility of central bank policies.
Macroeconomic stability is often accomplished gradually. Chile adopted the IT regime in two distinct
phases and implemented a solid macroeconomic framework based on central bank autonomy with a
clear focus on price stability. This was supported by a solvent, responsible, and predictable fiscal
policy and a solid and well-regulated financial system.
Chile's good record of attaining inflation levels close to the target has strengthened private sector
confidence in the CBC and raised MP effectiveness and credibility. Low inflation and a credible
monetary policy represent an essential macroeconomic achievement.
By improving its policy framework, supported by strong transparency, accountability, and
communication, the CBC has laid a major foundation to Chile's macroeconomic stability.
Yet the conquest and predictability of inflation are not guaranteed. The CBC will remain vigilant,
improving its policy framework as needed to continue delivering high levels of macroeconomic
stability.
References
Albagli, E. and K. Schmidt-Hebbel (2004), "By How Much and Why do Inflation Targeters Miss Their
Targets?", Mimeo, Central Bank of Chile.
Céspedes, L. and C. Soto (2005), "Credibility and Inflation Targeting in an Emerging Market: Lessons
from the Chilean Experience", International Finance 8 (3): 545-75.
Gürkaynak R., A. Levin, A. Marder and E. Swanson (2007), "Inflation Targeting and the Anchoring of
Inflation Expectations in the Western Hemisphere," in Monetary Policy Under Inflation Targeting,
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F. Mishkin, Central Bank of Chile.
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Targeting, Series on Central Banking, Analysis, and Economic
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Moody's Investors Service (2006), "Monthly Research".
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Inflation Persistence: The Mexican Experience", Working Paper N° 2007-01, Banco de México.
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