José De Gregorio: Price and financial stability in modern central banking
Keynote speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the joint
Latin American and Caribbean Economic Association (LACEA)-Latin American Chapter of
the Econometric Society (LAMES) Conference 2011, University Adolfo Ibáñez, Santiago,
11 November 2011.
* * *
I would like to thank Rodrigo Cifuentes, Luis Oscar Herrera, Alejandro Jara an Enrique Orellana for valuables
discussions and comments.
Introduction
It is a pleasure to address this audience at the main gathering of Latin American economists,
which brings together not only the best and more promising from our region, but also great
scholars from other parts of the world.
During my professional life I have had many challenges and jobs. I was in politics as Minister
in three portfolios a decade ago, and had of course to deal with politically sensitive issues.
Then I moved to the Central Bank. Many people tend to think that life in a central bank is a
quiet one. It is true, it is very low key compared to politicians', but requires hard work. During
my tenure as Governor we have had to deal with rising inflation, then the largest financial
crisis in the postwar period, followed by an earthquake, a change of the government coalition
after twenty years, and, more recently, inflationary shocks, exchange rate pressures and now
the European crisis and an increasingly weakened global economy.
This preamble is not to give my biography, but just to mention some of the things I have done
in my professional life, and to add that one of my most difficult and rewarding jobs so far was
to organize the LACEA conference in 1999. As a university professor we have access to
limited funds, so fundraising becomes a tedious, but necessary task. Then, organizing the
program and all the details is tough, and above all it is a task that has a strict deadline and
everything has to happen in just a few days. I had the privilege to meet and work with the
cochairman, Dominique Hachette, an extraordinary economist and friend. Our weekly meetings
in his house were really a pleasure, and we miss him a lot.
So, let me start by expressing my sincere congratulations and gratitude to the organizers.
However, I will not talk about organizing conferences, but about central banking. In particular,
I will refer to the new challenges facing central banks after the crisis and their role in securing
price and financial stability.
Central banks and price stability
Many years ago we reached consensus that central banks should focus mainly on ensuring
low inflation. Moreover, there were some scholars and practitioners that argued that price
stability should be the only objective of central banks, so the goal would be more credible
and monetary policy more effective in achieving stability. However, we didn't know how
exactly or operationally to achieve this target. Some central banks tried to target monetary
aggregates, others to peg nominal exchange rates, and others to use an eclectic mix of
indicators. Two decades ago, some central banks started conducting monetary policy
targeting a specific value or range for the rate of inflation. This trend started with New
Zealand in 1990, and was followed by Canada, the United Kingdom, Australia and Sweden in
the early 1990s. This is a case in which policy development led academic advances.
Progress in the academic front provided further impetus to the adoption of inflation targets as
new models were developed to provide the theoretical underpinnings of inflation targets and
the basis to conduct empirical work (Galí and Gertler, 2007).
This view was further justified by the success of monetary policy around the world in
providing stability, not only in the inflation front, but also in activity and employment. The
evidence that output volatility declined significantly in the US since the mid eighties was first
reported by Kim and Nelson (1999), and later called the Great Moderation by Stock and
Watson (2003).1 Several factors could be behind this fact, such as technical progress, better
policies, deeper financial markets, and sheer good luck. Although there is no final verdict,
there is evidence that points to the role of better macro policies (Galí and Gambetti, 2009).
However, it is interesting to note that emerging market economies also enjoyed a Great
Moderation, but it came in the second half of the 1990s, much later than in developed
economies, which coincides also with the time in which inflation was conquered, supporting
the hypothesis that it was good policies rather than good luck (De Gregorio, 2008). It is easy
to discredit the Great Moderation in the current juncture. However, the resilience of emerging
market economies to the global crisis was impressive. Indeed, emerging markets had a
recession, but much milder than in the past and with a remarkable recovery. And this was, of
course, the consequence of much better macroeconomic management.
The case of Chile illustrates this point. We did suffer a recession, but the size of the initial
impact and the speed of the recovery were quite different from previous episodes. In the
second half of 1998, affected by the Asian Crisis, Chilean GDP fell by 4.3% quarter to
quarter. Returning to the initial GDP level took us one year. But, comparatively, the
unemployment rate more than doubled between the beginning of 1998 and mid-1999,
reaching almost 12% and staying high, around 9.5%, until 2005. The effects of the
2008-2009 crisis were very different. Economic activity fell, but less than in the previous
episode, by 3% between the end of 2008 and mid-2009. The recovery was much faster and
only two quarters after the downturn, by the end of 2009, GDP was comparable to the
precrisis level. The growth rate after having recovered the initial output level was also different.
Considering the first six quarters after having reached this point, in the beginning of 2000, the
economy grew at an average annual rate of 4.4%, whereas between the first quarter of 2010
and mid-2011 the economy grew an average annual rate of 6.3%.
The behavior of the unemployment rate was totally different as well. After having risen from
around 7.5% in mid-2008 to levels close to 11% in mid-2009, it began a period of fast
decrease, returning to levels around 7% to 7.5% at the beginning of this year. The policy
regime was crucial in this result. Fiscal policy implemented a sizeable economic stimulus
package. Monetary policy also added a significant impulse to the economy, as the Bank took
the monetary policy interest rate to its minimum and implemented additional measures to
ensure the effectiveness of its actions. The effects of the 2008-2009 crisis were very
significant, but the resilience of the Chilean economy and the effectiveness of its
macroeconomic policies were even stronger.
Over time, inflation targeting regimes have evolved to what is now known as flexible inflation
target (FIT). In this scheme, the central bank sets an inflation target, which is intended to be
achieved in a given time horizon. As shown by Svensson (1997), inflation targeting implies
inflation forecast targeting. Thus, the central bank's inflation forecast at the policy horizon
becomes the intermediate target.2 In the case of Chile, our inflation target is three percent,
and the time horizon is two years. As long as this target is credible, monetary policy will not
only achieve inflation stability, but will also reduce the volatility of the business cycle.
Analytically, the FIT regime is based on the idea that the policymaker minimizes a loss
function that penalizes both inflation deviations from the target and deviations of output from
full employment. Therefore, what the FIT does is to optimize the tradeoff between output
volatility and inflation volatility. The time horizon is what makes this scheme "flexible." The
target is not achieved in the short run since it also takes the output costs of achieving the
target into account. A rigid inflation target is one in which the central bank only cares about
inflation, and hence the horizon would be the shortest possible, enough for monetary policy
to affect output. The longer the time horizon, the higher the weight of output volatility in the
loss function (De Gregorio, 2007). The time horizon typically extends to two years, or a more
ambiguous definition as "medium term." As long as medium-term inflation expectations
remain anchored, the monetary policy helps to reduce the volatility of other variables.
In addition, a FIT regime also requires a flexible exchange rate, so monetary policy can be
conducted independently. However, a proper FIT should help to stabilize the currency as
long as monetary policy should move leaning against the wind. For example, a persistent
depreciation of the currency, other things equal, should increase the inflation forecast,
although much more moderately than in rigid exchange rate systems. This effect should call
for a tightening of monetary conditions, reducing pressures against the currency.
Many times it has been argued, especially in non-professional discussions, that inflation
targets ignore output fluctuations. As I just argued, this is a mistake. Flexible inflation targets
take into account activity and employment, and this is implicit in the choice of the time
horizon. Moreover, a credible inflation target is efficient in terms of minimizing the tradeoff
between output and inflation fluctuations, and also helps to reduce real exchange rate
volatility. Indeed, a flexible inflation targeting regime can maximize welfare and perform much
better than an exchange rate or monetary target.
What variables should a central bank consider when setting the interest rate? In the regime I
just described, the answer to this question is pretty simple: anything affecting inflation over a
two-year horizon. Variables such as inflation expectations, wages, output, unemployment,
the exchange rate, commodity prices, and so on, have important effects on inflationary
forecasts and must be taken into account when deciding the future path of monetary policy.
However, it is also important that investors, wage and price setters understand and share the
importance of these variables for the inflation process. Communication is essential, and that
is the role of Monetary Policy or Inflation Reports, monetary policy statements, minutes,
projections, speeches, and so forth.
A key question during the financial crisis was to which extent central banks should react to
asset prices, such as housing or stocks prices. The answer from the perspective of inflation
target should be: as long as they affect the forecast of inflation, they should be considered in
the reaction function of monetary policy.
Asset price bubbles or distortions that may threaten financial stability should be considered
when evaluating financial vulnerabilities, but not influence monetary policy if they do not have
an impact on inflation. It is not clear that an increase in interest rates will be capable of
stopping an increase in asset prices. The required adjustments might be so large that they
could end up unnecessarily generating high unemployment and an undesired drop in
inflation. Under inflation targeting, any interest rate movements that is inconsistent with
inflation converging to the target may undermine the credibility of monetary policy,
destabilizing inflationary expectations and weakening the effectiveness of monetary policy.
Using monetary policy to burst a bubble in asset prices is particularly complicated in
emerging market economies, since bubbles in domestic assets generally take the form of an
exchange rate appreciation caused by large capital inflows. Tightening monetary policy to
burst the bubble may have perverse effects, since it induces further capital inflows and
strengthens the currency. In this case, the interest rate is not the appropriate instrument.
Exchange rate intervention could be a better policy tool.
Bringing back financial stability to central banking
With the global financial crisis, there was a renewed discussion on the role of central banks
in securing financial stability. This is not new. The first central banks (Sweden and the UK)
were created in the 17th century, but no proper role for central banks was established, and
indeed the Bank of England was founded to finance the war with France in the late
17th century (Davies and Green, 2010). It was not until the 19th century that the Bank of
England was given the monopoly for the issue of banknotes and assigned the role of lender
of last resort. Therefore, in the origins of central banking, its role was to secure the
functioning of the payment system. Thus, financial stability was not new, although it was a
secondary issue compared to the conduct of monetary policy, which gradually turned to
focus on price stability. Indeed, having central banks mainly one instrument, the interest rate
or the money supply, but not both, financial stability was mostly ignored.
This is not the case of emerging market economies, where after many financial crises, the
role of financial stability was always central in policymaking. Indeed, the most relevant aspect
of financial stability was in the international financial transactions area. For this purpose,
central banks, most usually, manage exchange rate policies, hold international reserves and
dictate norms to avoid currency mismatches and external payment crises. In Chile, the
Central Bank's objectives are price and financial stability. The Constitutional Law explicitly
establishes that "the Bank shall have as its purposes to look after the stability of the currency
and the normal functioning of internal and external payments."
Indeed, the resilience of financial systems in emerging markets during the global financial
crisis owes much to the fact that financial stability was already an important piece of the
policy framework.
Three issues I would like to discuss regarding financial stability and monetary policy:
 First, was the crisis caused by monetary policy?
 Second, what are the instruments for financial stability?
 And third, what are the interactions between financial stability and monetary policy?
Regarding the cause of the crisis, I do not think monetary policy, conducted, for example, on
the basis of a Taylor rule was the main culprit. Very low interest rates in advanced
economies induced high risk-taking as financial institutions were searching for yields. Excess
liquidity may sow the seeds for asset price bubbles and financial vulnerabilities,3 but to cause
a huge financial crisis, some serious distortions in the financial system are required. Indeed,
countries like Australia or Canada had very low interest rates, but their financial systems
responded appropriately to the financial crisis. Chile also followed an interest rate cycle
similar to that of the US and did not suffer a financial crisis. In some countries there could
have been even a housing bubble, but there was not the degree of leverage as in the US,
which was central in triggering the crisis. Indeed, it is useful to recall that asset price bubbles
do not necessarily cause a financial crisis, as was the case with the tech bubble in the early
2000s. The bad combination is asset price bubbles with high leverage in the banking system.
However, monetary policy played a role in the crisis in the way it dealt with bubbles, deviating
from the prescriptions to pursue price stability. This was the so-called "Greenspan put." The
rule followed by the Fed was not to react to the formation of a bubble, but to mop-up its
effects after the bubble burst. This was done by providing unlimited amount of liquidity and
sharp reductions of interest rates. Recent evidence confirms that including asset price
deflation improved the fit of the Taylor rule (Hall, 2011), and hence markets were expecting
an easing of monetary conditions when asset prices declined significantly. This point was
already raised almost ten years ago by Miller et al. (2001), who argued that eliminating
downside risk of asset prices feeds the bubble, so more bubbles were not only the result of
irrational exuberance but was also "exaggerated by the faith in the stabilizing powers of Mr.
Greenspan."
Regarding the second question, on the instruments for financial stability, this is what has
been termed macroprudential tools, as opposed to the microprudential regulation, which
targets the health of specific financial institutions. One of the first tools used for financial
stability was the dynamic provisions to housing loans implemented in Spain in 2000. It is still
too early to have a full evaluation of this instrument, since it did not avoid a housing bubble,
many small institutions dedicated to housing finance, the "cajas", went bust during the crisis,
but the overall Spanish financial system fared well through it all.
On the time dimension, the idea of macroprudential tools is to avoid the buildup of financial
vulnerabilities in the upturn of the business cycle, and to have a cushion for the downturn.
Financial systems tend to be procyclical, and hence some break system should be
implemented to avoid excessive risk-taking. This has been underlying the new rules in
Basel III, especially in the definition of the countercyclical buffer of new capital requirements.
On the cross-section dimension, extra capital has been proposed for systemic institutions in
order to make them more resilient to financial turbulences. But, the definition of systemic
institutions is still blurred, and given the evolution of financial innovation, what today may be
a non-systemic institution may eventually become systemic. Indeed, a non-systemic
institution on a worldwide basis could be systemic from the point of view of particular
economies.
Again, these issues are not new in emerging market economies, which in general have more
capitalized banks. In Chile, most of the industry already satisfies the requirements that are
supposed to be in place by 2019. Moreover, there are larger requirements for banks that
have high market share.
There are other areas where we have already made significant progress, such as restrictions
on currency mismatches, liquidity management and the use of derivatives. In all of these
cases, the Central Bank of Chile has authority to set prudential regulation. For banks, these
relate with authorizing the use of derivatives, regulation regarding market and liquidity risk,
among others. In other areas, the Central Bank also has a say in "systemic" regulation, such
as overall limits for Pension Funds. This scheme accommodates recent policy concerns,
since it avoids the conflict of interests that arises from mixing the micro supervisor with the
monetary authority, while preserving an institution that provides a broad look at the stability
of the financial system. This being said, however, there is a need to continue strengthening
coordination instances with other regulators. In this sense, the recent creation of a Financial
Stability Committee in Chile should improve coordination among regulators and have a view
on financial stability and risks. Over time, and as learning takes place, some legislation
should be introduced in order to enhance the effectiveness of the Committee. In the Central
Bank, evaluation of financial vulnerabilities and strengths is performed bi-annually in our
Financial Stability Report.
Finally, regarding the interactions between macroprudential policies and monetary policy, I
would like to make some comments.4 The traditional view has been influenced by the
Tinbergen principle, by which there should exist as many instruments as policy targets. This
view is reinforced by the fact that, as I argued above, the interest rate is too blunt of an
instrument to deal with asset price bubbles and financial dislocations. Therefore, we can
think of a separation between the interest rate - the monetary policy instrument to achieve
the inflation target - and macroprudential tools to deal with financial stability.
However, and perhaps unfortunately, the separation is not that clear. As I discussed before,
actions of monetary policy, such as the Greenspan put, may create financial instability. The
financial crisis also showed that it has effects on the business cycle and, hence, it has
implications on monetary policy. Moreover, the transmission channels of monetary policy
could be broken down during a crisis. Therefore, the state of the financial system should
have implications on the conduct of monetary policy of economies following a FIT regime
since it affects the transmission channels and the business cycle.
Another issue is whether macroprudential tools may be used to complement monetary policy.
For example, adjusting capital requirements over the cycle or introducing dynamic
provisioning may have effects on the output gap, inflation and interest rates. This is similar to
the case of automatic stabilizers of fiscal policy, which of course have implications on
monetary policy. Therefore, there should not be conflicts between financial stability and price
stability tools, as long as financial regulation reduces the procyclicality of the banking system.
From the point of view of the inflation target, this is just part of the environment in which
decisions have to be made.
Perhaps a more controversial issue is the use of macroprudential tools as a substitute for
monetary policy. A recent case in some emerging markets has been the use of banks'
reserve requirements to tighten credit by reducing the need to increase the interest rate, and
collateral effects on asset prices, especially the exchange rate.
The advantage of using the interest rate for monetary policy is that we have relatively good
knowledge of the transmission channels. Changes in monetary policy interest rates affect the
cost of financing, asset prices and the availability of credit. The macroeconomic
consequences of changing regulation are less well understood. Tightening restrictions on
banks may create disintermediation and move credit to unregulated segments of the market.
In addition, the latitude of changes in regulation is much more limited than that of interest
rates. A more constructive approach may be to design rule-based countercyclical regulation
with a clear purpose to minimize the risk of financial crisis. Nevertheless, we still need to
learn more about the interactions between monetary and financial policies.
Final remarks
A natural reaction to a crisis is to think that everything is wrong and that all must be changed.
Emerging markets, and in particular Chile, performed well during the crisis, and above all
during the recovery. Therefore, a first lesson must be on the factors that produced these
good results, and macroeconomic management was certainly central to the rapid recovery.
The financial system was resilient, which shows that the regulatory framework was
appropriate. However, our role is not to congratulate ourselves for our achievements in the
past, but to look at strengthening our macroeconomic framework.
As development proceeds, new challenges arise due to financial innovation, and it is
extremely important to look for lessons while the crisis unfolds, to take advantage of financial
development without risking financial stability. There is a need to study the interactions
between monetary and financial policies further, especially given the challenges stemming
from the global outlook.
Implementing monetary policy in a flexible inflation targeting framework has shown its
benefits; incorporating financial frictions and the appropriate policies should help us to
navigate better in a very uncertain world.
The crisis also left some lessons for the profession and the way we use our highly stylized
models in policy-making. The narrow view is to think they are a precise description of how
the world works, when in truth it is much more complicated. However, the other extreme view
- and a very bad one for policy-making - is disregarding all that we have learned from
academic work. We need to be humble about the extent of our knowledge, but we also have
to be rigorous and serious about policies.
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