REMARKS BY MR. JAVIER GUZMÁN CALAFELL, DEPUTY GOVERNOR AT THE
BANCO DE MÉXICO, ON "MONETARY POLICY AMID VOLATILE CAPITAL
FLOWS". SCOTIABANK GLOBAL CENTRAL BANK & PUBLIC INSTITUTIONS
CONFERENCE. Miami, April 6th, 2017.1
First of all let me say that I am very glad to participate in this Conference. My
sincere thanks to Scotiabank and especially to Alejandro García for the
invitation.
The implementation of monetary policy under volatile capital flows has for
long been a challenging issue for emerging market economies (EMEs).
Naturally, with globalization and the consequent increased integration of the
world economy, the difficulties have become more acute. As is well known,
the combination of a number of factors, including domestic financial
liberalization, a widespread removal of cross-border controls, and the
development of financial technology, has brought about a dramatic expansion
of international financial transactions in recent decades.
But the complexities of these trends have been substantially accentuated as a
result of the global financial crisis. The pressures resulting from the crisis
forced the central banks of many advanced economies (AEs) to reduce short-
term interest rates to very low, even negative levels, which resulted in turn in
historically low figures for long-term rates. This led to an aggressive search for
yield and a boost to capital flows towards EMEs, giving as a result
macroeconomic and financial stability challenges for these countries.
Subsequently, as the situation has begun to improve in the AEs, and especially
in the United States, EMEs have faced the need to cope with the opposite
challenge, i.e. a tightening of external financial conditions and episodes of
capital outflows, although in a context of wide swings, with the corresponding
stresses on domestic and external stability. The situation has been further
complicated by divergent monetary positions among the main AEs and by
periodic bursts of turbulence.
Naturally, the challenges deriving from the global financial crisis do not end
here. On the one hand, it has had long-term effects on the world economy,
including a lower rate of potential growth, a decline in commodity prices, and
a substantial increase in global uncertainty, among others, that have
significantly deteriorated the external environment faced by EMEs. On the
other hand, the costs that have accompanied the crisis have underpinned a
backlash against globalization, which is threatening to undermine the
economic progress achieved over many decades of efforts.
At the same time, the crisis has given rise to deep question marks about our
understanding of economics, in general, and of monetary policy in particular.
For instance, it has become increasingly evident that while the possibility of
implementing an independent monetary policy is greater under exchange rate
flexibility, floating implies costs that set limits on the degree of independence
a central bank can enjoy. Furthermore, doubts have emerged regarding the
adequate monetary policy framework under current circumstances, the merits
of intervention in the foreign exchange market, the role to be played by
monetary policy in the preservation of financial stability, and the use of capital
controls as a means to counter the adverse effects of volatile capital flows,
among others.
How has monetary policy in Mexico responded to these challenges?
At present, the implementation of monetary policy in Mexico rests on four
pillars.
First, an independent central bank with the mandate to focus on achieving a
low and stable rate of inflation. Both features, as well as the key provision that
no authority will be able to order the Banco de México to provide financing,
are stipulated at the constitutional level.
Second, an inflation targeting regime, with a specific target for headline CPI
annual inflation of 3 percent within a variability interval of +/- 1 percent, and
where convergence to the target is sought at the lowest possible cost in terms
of economic activity.
Third, a commitment with transparency and clear communication of actions
and goals of the Central Bank.
Fourth, awareness that under a situation of high uncertainty, there are clear
merits of an approach emphasizing prudence and readiness to act on a
preventive basis whenever this is considered convenient.
Naturally, an efficient achievement of the macroeconomic objectives requires
a balanced policy approach. It may be useful to note, for instance, that the
global financial crisis has evidenced the costs derived from a policy response
that relies excessively on monetary policy. In the case of Mexico, two elements
are central in this regard:
 The implementation of measures aimed at fostering an orderly
functioning of the foreign exchange market in a context of sharp
depreciation and high volatility of the peso-dollar rate. With the support
of a comfortable level of international reserves and a Flexible Credit Line
with the IMF, actions taken by the Foreign Exchange Commission2 have
varied according to circumstances, and have included pre-announced or
sporadic discretionary interventions in the foreign exchange market
and, more recently, the introduction of a new mechanism for the
hedging of foreign exchange risk for an amount of up to USD 20 billion,
which in fact does not imply the use of international reserves. The latter
has contributed to the significant appreciation shown by the peso in
recent weeks.
It is important to note that this approach is fully consistent with a
flexible exchange rate regime that plays a key role as a shock absorber,
which operates under the premise that the level of the equilibrium real
rate must be determined by market forces, and where the value of the
domestic currency is supported mainly by economic fundamentals.
 Against the background of an increase in public debt as a share of GDP,
a major fiscal adjustment has been announced for 2017 and subsequent
years. Indeed, the strict implementation of these measures should allow
more flexibility in the conduct of monetary policy and, therefore, a more
efficient economic adjustment to an adverse external environment.
The role of monetary policy in preserving or restoring financial stability is a
subject of much debate. Macroeconomic stability is a necessary although
insufficient condition for financial stability, and of course monetary policy is a
key element in this regard. But the role of monetary policy beyond this is not
always clear. In my opinion, although there may be instances where monetary
policy actions can be usefully steered towards financial stability, frequently its
effects on the broader economy beyond the financial sector will make it a blunt
and inefficient tool. For this reason, it will often be better to rely on the
implementation, with the involvement of all the corresponding authorities, of
macroprudential policy measures specifically tailored to fend off risks to the
stability of the financial system, and which in general do not have
consequences beyond their intended purpose. It should be noted, on the other
hand, that financial stability is a complex objective that will many times require
coordinated actions in several fronts, including, in addition to macroprudential
instruments, fiscal, monetary and microprudential policy tools. The Financial
System Stability Council (CESF), created in Mexico in mid-2010, and which
encompasses all the authorities in charge of macroeconomic policy, and
financial regulation and supervision, represents an effort in this direction
Naturally, the pernicious implications of volatile international capital flows on
macroeconomic and financial stability are hard to avoid. In this context, the
possible implementation of measures to "manage" the flows of capital to and
from an economy has been gaining adherents. However, the distortions
introduced by capital controls are likely to offset any potential benefits, and
markets, one way or another, always find a way to circumvent them.
Consequently, this has not been considered a sensible course of action in the
Mexican case, and the country remains one of the most open to capital flows
among emerging market economies.
The approach I just described has allowed a flexible implementation of
monetary policy in Mexico with satisfactory results. Let me illustrate this with
the experience of recent years.
In the aftermath of the global financial crisis, as in other EMEs, significant
downward pressures on economic activity emerged in Mexico. As a result,
the Central Bank embarked on an aggressive cycle of cuts to the policy rate,
which during the six-month period from January to July 2009 declined by
nearly 400 basis points. External developments also played an important role
in this outcome. In particular, the Federal Reserve's lowered the target for
the federal funds rate by about 500 basis points over the 15 months between
September 2007 and December 2008.
Subsequently, following a relatively prolonged period with an unchanged
monetary policy stance, the reference rate in Mexico was reduced by an
additional 150 basis points between March 2013 and June 2014. The
combination of a negative output gap, easy external financing conditions3
(barring the "taper tantrum" episode of mid-2013) and a generally stable
exchange rate, allowed the simultaneous achievement of record-low inflation
and policy interest rates. In particular, the reference rate remained constant
at its lowest historical level of 3 percent for slightly over a year and a half, while
overall inflation fell below the 3 percent target.4
More recently, with the beginning of the normalization of interest rates in the
United States in December 2015, an upward trend in interest rates in Mexico
has started. This has responded to a combination of factors, including of
course the higher federal funds rate, but also a preventive response by the
Banco de México during 2016 to the potential impact of the significant
depreciation of the peso on domestic prices and, since early this year, the need
to avoid second round effects from an inflation spike deriving from the
liberalization of energy prices, an adjustment of the minimum wage and a
more evident pass-through from the exchange rate to prices.5 Thus, from late
2015 to March 2017, the reference rate has been increased on 8 occasions, to
a level of 6.5 percent.
The monetary policy framework adopted in Mexico in recent years has been
fundamental to preserve macroeconomic stability in a context of highly
volatile capital flows and severe external shocks, such as the sharp decline in
oil prices, bouts of uncertainty in international financial markets linked to
geopolitical or other factors, the increase in interest rates in the United States
and the results of the electoral process in that country. Furthermore, together
with micro- and macroprudential measures implemented over the course of
many years, it has contributed to the preservation of financial stability.
Naturally, many challenges remain. The most evident one in the short term is
to ensure that the recent increase in inflation does not affect medium- and
long-term inflation expectations and the process of price formation in the
economy. In this respect, it is worth to note that the fact that the impact of
the most recent shocks on prices has concentrated mostly on short-term
inflation expectations, with a sharp downturn in price growth anticipated since
early 2018, attests to the merits of the actions undertaken thus far and in
general to the credibility of monetary policy. On the other hand, it is evident
that monetary policy in Mexico will continue to be implemented under very
uncertain and changing conditions. Therefore, the Central Bank will need to be
ready to adapt the monetary policy stance as needed to ensure an efficient
accomplishment of its mandate.