REMARKS BY JAVIER GUZMÁN CALAFELL, DEPUTY GOVERNOR AT THE
BANCO DE MÉXICO, ON "MONETARY POLICY AMIDST NAFTA NEGOTIATIONS
AND OTHER SOURCES OF UNCERTAINTY". EUROPEAN ECONOMICS AND
FINANCIAL CENTRE'S DISTINGUISHED SPEAKERS SEMINAR. London, July 9,
2018.1
I am very honored for the opportunity to participate in this Seminar and to
address such a distinguished audience. You will not be surprised if I say that I
am also very impressed by the venue. The Palace of Westminster is not only
one of the most beautiful sites in the United Kingdom, but also a revered
symbol of history and democracy. I thank the European Economics and
Financial Centre, and especially Professor Hannah Scobie, for the invitation to
take part in this event, and Baroness Gloria Hooper for kindly agreeing to chair
it.
I will concentrate my remarks on monetary policy in Mexico, with a special
emphasis on the environment of uncertainty that has been affecting us for
several years already and on one of its main ingredients, the renegotiation of
the North American Free Trade Agreement (NAFTA).
The Banco de México's primary mandate, enshrined in the country's
Constitution, is to seek the stability of the purchasing power of the national
currency, that is, a low and stable inflation. This is based on a wide body of
evidence leading to the conclusion that this is the best contribution that a
central bank can make to a country's growth and well-being. To this end, the
conduct of monetary policy in Mexico rests at present on three main pillars
which, although mutually reinforcing and therefore complementary, have
been sequentially erected through efforts made over the course of several
decades.
First among these, is the autonomy that our Central Bank has enjoyed since
1994. This resulted in part from a growing global trend that, in light of
mounting evidence highlighting the beneficial effects of central bank
autonomy on inflation and growth, sought to equip national monetary
authorities with the institutional features that would allow them to formulate
policy with a long-term perspective and isolated from political interference. In
the Banco de México's case, the importance of moving in this direction was
more evident given the need to prevent the re-emergence of damaging
inflationary episodes of the past, which had resulted from the use of central
bank money to finance fiscal deficits. Indeed, the independence granted to the
Central Bank is one of the most transcendental institutional reforms in
Mexico's modern history.
A second pillar consists of the adoption, since 2001, of an inflation targeting
regime. By assigning a numerical value to the goal for monetary policy, these
frameworks have allowed central banks of both advanced and emerging
economies to rely on a more efficient nominal anchor to guide inflation
expectations. At the same time, they have strengthened the institutional set
up for the implementation of monetary policy. In the case of Mexico, a target
of 3 percent has been set for annual CPI growth, with a variability interval of
plus/minus 1 percent to take into consideration the multiple shocks that can
affect relative prices in the short term. Inflation targeting has proved
instrumental in reducing inflation in Mexico, and is associated with important
structural changes in the process of price formation in the economy -a
decreased pass-through of the exchange rate to prices, a lower persistence of
inflation and a much stronger resilience of long-term inflation expectations to
supply shocks, among them.
Thirdly, transparency and accountability have been given a prominent role in
the implementation of monetary policy. This is inherently imbedded in the
nature of the above-noted inflation targeting framework. The target itself
provides the yardstick against which outcomes are measured and evaluated.
Further to this, continuous and incremental efforts have been made by the
Banco de México through a comprehensive and evolving communication
strategy with the public. This has been fundamental, since the relative
importance of inflation expectations as a transmission mechanism of
monetary policy actions has increased since the adoption of the inflation
targeting regime. As I will explain in more detail below, additional efforts to
increase transparency and accountability have been set in motion lately.
The implementation of monetary policy in Mexico has been subject to major
challenges in recent years as a result of a combination of elements.
Although the world economy has shown a clear improvement after the Global
Financial Crisis, this has been accompanied by the emergence of a number of
risks that have stirred up an atmosphere of uncertainty. The sources are
diverse and complex: a tightening of global financial conditions, persistent
vulnerabilities in several advanced and emerging economies, increased
protectionist pressures, a growing anti-globalization sentiment, and problems
of a political or geopolitical nature, among others.
In this context, Mexico's economy has been hit by several shocks, of both a
domestic and external origin, since the second half of 2014:

The combination of a sharp decline in oil prices2 and in Mexico's oil-
producing capacity,3 led to a reduction of fiscal revenues from this
source from 8.8 percent of GDP in 2012 to 3.8 percent in 2017.4

Uncertainty associated to the possible trajectory of interest rates in the
United States, to a significant extent driven by the risks deriving from
fiscal expansion in an economy operating around full employment, has
been sharper in Mexico than in other EMEs, given tight links with the US
economy and a high degree of openness to foreign capital flows.
 The 2016 presidential election in the United States and its aftermath
have resulted in unease regarding the prospects for the economic
relationship between the two countries in coming years.
 The renegotiation of NAFTA has become a focal point of attention for
both domestic and foreign investors, in view of the importance of this
Agreement for the region, both from an economic and an institutional
point of view.
 The potential economic and political implications of the recently
concluded electoral process in Mexico, where a new President, Congress
and several state Governors were elected, has also been a source of
uncertainty.
 Partly as a result of several of the above factors, the availability of
external financing declined significantly, from an annual average above
4 percent of GDP in 2013-14, to some 1.5 percent in 2015-17.
The Mexican economy has adjusted to these shocks through a number of
channels. Chief among them is the significant depreciation of our currency
since September 2014 which, in terms of its value vis-à-vis de US dollar,
accumulates to date around 46 percent, a metric that at some stages has
recorded figures nearing 70 percent. Of course, notwithstanding the
abovenoted reduction in the pass-through coefficient, this has had important
implications for inflation. Although relatively contained during the initial
stages of this process, the inflationary pressures deriving from exchange rate
depreciation and a series of supply shocks that took place during 2017,5
resulted in an upturn in annual inflation to levels that in December of that year
reached figures (6.77 percent) unseen since May 2001.
What has been the response of monetary policy to an environment
characterized by increased inflationary pressures and high levels of
uncertainty?
First of all, I wish to note that, as in the entire realm of economic policymaking,
uncertainty is inherently embedded in the set of conditions under which
monetary policy is conducted. The problem in the recent Mexican experience
is that uncertainty has risen to levels well above those that can reasonably be
deemed normal. This is the case because, as explained above, it includes
events of paramount importance, complex in nature, that tend to appear only
sporadically, and where the related risks can materialize simultaneously.
In my view, under conditions like these, central bank authorities should at least
consider the following:

Enhancing communication is essential under a situation of high
uncertainty, since understanding monetary policy actions becomes
more difficult in these circumstances. Therefore, additional efforts are
needed for a proper grasp of the central bank's reaction function and its
assessment of the present and future economic situation.

The responsibility of a central bank to adhere to its mandate is
unaffected by uncertainty. In other words, uncertainty should not lead
to excuses or indecision. The issue here is how to optimize the
information used for decision-making, and how to balance the risk of
having insufficient information vis-à-vis reacting too late.

Erring on the side of caution will usually be preferable under a situation
of high uncertainty. This rests, on the one hand, on the premise that it
is better to be prepared for events with a small probability of occurrence
but a potentially high cost and, on the other, on the fact that assessing
the probability of a disruptive event becomes far more difficult in the
presence of high uncertainty. In this process, it is fundamental to give
proper weight to the large costs, both for the institution and the
economy, resulting from a hit to the credibility of the central bank.

Models are useful to support monetary policy decisions but they have
well-known limitations, and the possibility of mistaken prescriptions is
positively related to uncertainty. Therefore, the role of judgement will
become even more important with higher levels of uncertainty.

The merits of a coordinated use of policy instruments are well known:
potential to exploit synergies, less likelihood of overburdening policy
instruments and reduced costs for the economy, among others. For
obvious reasons, the advantages of this approach are clearly enhanced
as uncertainty levels increase.
The strategy adopted by the Banco de México to face the complex
circumstances of recent years is consistent with these principles. In general,
the implementation of monetary policy has emphasized prudence, and timely
and firm action whenever necessary. Thus, from December 2015 to date, the
monetary policy interest rate has been increased on 13 occasions, by a total of
475 basis points.
In general terms, actions by the Central Bank during this period have been
aimed at ensuring the convergence of inflation to the 3 percent target, at the
least possible cost for economic activity. In this context, monetary policy
actions have responded to different sorts of circumstances, such as: hikes in
the reference rate in response to equivalent measures by the Federal Reserve,
to mitigate the potential for disorderly capital outflows given the high degree
of openness of the Mexican economy and the prevailing conditions of
uncertainty; adjustments during episodes of steep depreciation of the
exchange rate, even with relatively low levels of inflation, to contain the
passthrough to domestic prices and to avoid second-round effects from these
shocks; and a decisive response to sizable supply shocks which, combined with
a substantially depreciated exchange rate, threatened to affect the process of
price formation in the economy and, therefore, an unanchoring of long-term
inflation expectations.
Furthermore, as mentioned above, in an environment of high uncertainty it
has been considered important to enhance the transparency and
accountability of the Central Bank's actions. Consequently, since February of
this year, information is provided regarding the time lapse over which inflation
is expected to converge to the target. Thus, quarterly forecasts for the
trajectory of both headline and core inflation over the period of influence of
monetary policy are published. This is anticipated to reinforce the role of the
Central Bank in the determination of inflation expectations. Subsequently, in
April, the decision was taken to identify voters in the minutes of the Board of
Governors monetary policy decisions, and to release the full transcript (with a
3-year delay) of said meetings, among other measures.6
In addition to the flexible exchange rate mechanism -which has worked as an
efficient shock absorber- and sporadic interventions in the foreign exchange
market, monetary policy has been supported by other policy tools. The
strengthening of fiscal policy in recent years has been of crucial importance,
given the pernicious effects that weak fiscal positions can have on inflation
expectations, interest rates and the exchange rate. Efforts spanning over
several decades to strengthen the financial system have also been
instrumental, as the latter has allowed an efficient transmission mechanism
for monetary policy and a sharp increase in interest rates without significant
adverse side effects on banks or other financial institutions.
Despite the fact that some ground still needs to be covered on the road to
bringing inflation back to target, and the remaining important risks , the results
obtained thus far are encouraging, especially in light of the magnitude of the
shocks that have affected our economy. Inflation has been on a downward
trajectory over the course of 2018, with headline figures falling from 6.77
percent at the end of 2017 to 4.65 in June of this year, consistent with the
Banco de México's projections. Furthermore, long-term inflation expectations
have remained stable, although at around 3.5 percent. On the other hand, the
recent materialization of some upside risks may imply a revision of the period
over which inflation is expected to converge to the 3 percent target. It is
worthwhile to highlight that economic activity has not been significantly
affected by the monetary policy stance, as evidenced by the 33 consecutive
quarters of positive annual GDP growth recorded as of early-2018, and
expectations of an output gap around zero during this year and the next.
To conclude, let me say a few words about NAFTA, that may contribute to
understand why this is at present one of the main sources of uncertainty for
the Mexican economy.
Even though the economic integration of the Mexican, Canadian and US
economies had been underway well in advance of the enacting of this
Agreement in 1994, and while some have argued that said process would have
continued even in absence of NAFTA,7 the key role it has played in the
acceleration, deepening and widening of the linkages among its member
countries over the nearly 25 years it has been active is indisputable.
Naturally, the main channel through which NAFTA has boosted the region's
integration has been trade. In fact, by 2017, the value of merchandise traded
between the three member countries had nearly quadrupled relative to the
levels registered in 1993, while bilateral trade between Mexico and the United
States showed a six-fold increase during the same period. In light of the above,
it comes as no surprise that, with an 80 percent share of the total, the United
States is the main destination for Mexico's exports, while Mexico is the second
largest foreign market for US goods, surpassed only by Canada. Taken
together, US exports to both Mexico and Canada amount to over one third of
that country's shipments to the rest of the world.
Notwithstanding the breadth of the US-Mexico trade relationship that may be
depicted by the above figures, a more detailed look at the data reveals some
additional features that are worth highlighting. Mexico is among the top 2
export destinations for 27 US states, a figure similar to that of the states (28)
that count Mexico as one of their 3 main sources of imports. Texas, for
instance, is not only the main destination for Mexican exports within the US,
but also overall, as it accounts for nearly 22 percent of all Mexican sales
abroad, a figure significantly above those for countries such as Canada (2.8
percent), Germany (1.7 percent) and China (1.6 percent). Conversely, Mexico's
imports from Texas are greater than those from China, and we buy more from
California than we do from countries such as Japan, Germany and South Korea.
The region's economic integration that has come about as a result of NAFTA
goes far beyond the free international flow of goods and services. It could
hardly be argued that this is just a case of three separate economies trading
finished goods among them. On the contrary: they are producing many of
those goods together, specializing in different stages of the corresponding
production processes through the implementation of cross-border supply
chains that enhance their competitiveness, both individually and jointly, in
markets abroad. Therefore, as in other regions of the world, intermediate
goods in North America cross borders multiple times before reaching final
consumers. An input-output analysis of the productive activity in Mexico and
the United States shows that, in both countries, around 20 percent of the total
value added generated domestically by these countries' manufacturing sectors
is destined to activities abroad immersed in Global Value Chains (GVCs).8
By including protective rules and procedures for cross border investors, as well
as dispute settlement mechanisms for both trade and investment flows,
NAFTA has given rise to a massive expansion of foreign direct investment
among the three members. For instance, annual US direct investments in
Mexico have multiplied by 4 since the creation of NAFTA, while the
corresponding flows from Canada have increased by a factor of nearly 37,
albeit from a very low base.
Naturally, the renegotiation of NAFTA provides the opportunity to update an
agreement signed more than 20 years ago, and to increase its beneficial effects
for the three countries. I hope that, in the end, common sense will prevail, and
that both the realized and still ample scope for mutual gains will result in a
strengthened Agreement and an even deeper integration within the North
American region.