José De Gregorio: Autonomy of the Central Bank of Chile, 20 years on
Presentation by Mr José De Gregorio, Governor of the Central Bank of Chile, at the
commemoration of the 20 years of autonomy of the Central Bank of Chile, organised by
ICARE, Santiago, 29 October 2009.
I thank Luis Felipe Céspedes and Jorge Restrepo for valuable comments and ideas in preparing this presentation.
* * *
The autonomy of the Central Bank of Chile is enshrined in the Constitution, specifically in the
Basic Constitutional Act of the Central Bank of Chile enacted in October 1989 that
constituted a fundamental change for the functioning of the Chilean economy.
The Law stipulates that the Central Bank is an autonomous entity, of a technical nature,
created in accordance with constitutional provisions, with full legal capacity, the full owner of
its assets and of indefinite duration. Its third article states 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." It then adds that "the authority of the Bank, for these purposes, shall
include regulating the amount of currency and credit in circulation, the performance of credit
transactions and foreign exchange, as well as the issuance of regulatory provisions
regarding monetary, credit, financing and foreign exchange matters."
In addition, it establishes that "no public expenditure or credit of any nature may be financed
either directly or indirectly with loans granted by the Bank." Finally, article six states that
"when passing its resolutions, the Board shall consider the general orientation of the
Government's economic policies."
This is a clear mandate for the Central Bank of Chile, by which it establishes instruments and
mechanisms for the designation and removal of Board members, as well as vehicles for
coordination with the Executive.
In addition, its autonomy is further reinforced and legitimated through the achievement of
said objectives and by the Bank's communication and transparency policy, whose effects go
far beyond the provisions in the law regarding the obligation to inform about its decisions.
In this presentation I will address some of the main elements concerning the autonomy of
central banks, as well as an evaluation of the principal accomplishments of the past twenty
years.
The reasons for pursuing autonomy
High inflation is costly for society because it is associated with higher price volatility, which
distorts resource allocation. Erroneous price signals lead to mistaken investment decisions,
that is, to a less efficient use of resources, which reduces the economy's productive capacity
and, ultimately, its growth.
There is abundant evidence of the harmful effects of inflation on long-term growth (Barro,
1995; De Gregorio, 1995).
But, why does inflation tend to be higher when the central bank is not autonomous?
To begin with, there is a need for public expenditure financing. There are various reasons
why there is always pressure to increase public spending. Many of them are well-known and
it is beyond the purpose of this presentation to discuss them. The truth that this tendency to
raise public spending combined with the fact that the inflation tax is easy to collect, creates a
natural pressure towards higher inflation.
Numerous episodes where fiscal objectives have dominated price stability goals have
resulted in significant inflationary spirals, which are very costly for society. This fact is
wellknown in Chile and in the rest of our region.
A second element behind the inflationary bias has to do with the so-called dynamic
inconsistency problem. In parallel with the tendency of the government to increase public
spending comes the incentive to boost economic activity above sustainable levels. There are
several reasons for this to occur. Potential market failures may result in a less than socially
optimal output level, or political cycle motives can lead the central bank to try to boost
economic activity beyond the level believed to be sustainable in the medium term. How can
the government (the central bank) generate a higher output level? By surprising economic
agents with a higher than expected inflation rate. The inflationary surprise increases
aggregate demand and output.
However the public fully understands this situation, so the final result will be higher inflation
and output at the same level as it would have reached without the inflationary surprise.
Inflation cannot generate permanent increases in output. In other words, more inflation is
created but not more activity, which reduces welfare.
Granting autonomy to the monetary authority has been a way to establish a credible
commitment with price stability while, at the same time, allowing it to implement a monetary
policy that helps to smooth the business cycle.
To the extent that the central bank is independent of the government's financing needs, the
inflationary bias that is attributable to financing a recurring public deficit will be eliminated.
In addition, increasing the horizon of a central bank, which is related to greater
independence, reduces the dynamic inconsistency problem because its interaction with
economic agents is repeated over time. Within this context, the central bank's reputation acts
as a self-regulating mechanism for its behavior. Therefore, the longer the planning horizon of
the central bank, the greater the probability of it implementing efficient policies. This
significantly strengthens the capacity of the central bank to deal with external shocks.
For an open economy like Chile, the credibility of its central bank can have important effects
on competitiveness. A credible central bank, where inflation expectations are anchored, will
experience a smaller pass-through coefficient from the exchange rate to inflation. This allows
the central bank to respond with more flexibility to shocks requiring a real exchange rate
depreciation.
To summarize, if there is confidence in the central bank's anti-inflationary commitment, the
central bank can react more flexibly to various shocks and, in this way, minimize deviations
of output from its potential level.
The central bank can smooth the business cycle while preserving price stability. The key
element in this strategy is the credibility of the central bank's commitment to price stability,
for which communication and transparency are crucial.
Autonomy and transparency
Autonomy means that the State delegates to the central bank the administration of monetary
policy, such that it be applied using technical criteria and with a medium-term horizon. Here
is the first reason why central banks must be transparent: to preserve the legitimacy that an
autonomous institution must have in a democratic regime, particularly one whose decisions
have important implications on the nation's well-being. Autonomous institutions must properly
inform the country of their actions.
In Chile, the delivery of information is determined in the Basic Constitutional Act, which
establishes that, once a year, the Bank must inform the President of the Republic and the
Senate about the general policies and regulations it dictates in exercising its mandate. This is
done every September, when the Board of the Central Bank presents its Monetary Policy
Report (IPoM) before the full Senate. Nonetheless, the Bank has substantially enlarged its
information disclosure function, taking important steps forward during this year. First, since
March, the background minutes prepared by the Research Department are published on our
website the day before the monetary policy meeting. This way, the public has the same
background information as the Board does when making its monthly monetary policy
decisions. Also, the Board announced that, as of next December, it will increase the
frequency of the IPoM from three to four issues per year.
Financial Stability Report
Additionally, the Bank publishes the twice a year, in December and
June, and publishes its yearly account on the administration of international reserves once a
year as part of its Annual Report.
But this is not enough. Legitimacy is strengthened through direct, open, and non-exclusive
communication with the general public and, for that reason, the aforementioned documents
are uploaded onto our website at the same time as they are being presented. In addition, the
Bank issues other reports, communiqués, minutes, specialized studies and statistical
publications, all of which are available to the public. These are complemented by
presentations by Board members or staff, which are also uploaded to the website.
The times when central banks' operations were complex and indecipherable are being left
behind. It is our objective - although it is difficult to accomplish - that the community
understands our work, which is to provide the public good of stability that allows the country
to progress, and is not an operation carried out by technocrats with incomprehensible
criteria.
There is another important reason why central banks need to be transparent: the efficacy of
monetary policy. In the past few years, advances have been made towards consensus that a
more predictable monetary policy is better, without itself being a source of noise and
instability. To that end, it is necessary to properly communicate our vision of the way the
economy works and how monetary policy decisions affect inflation.
Results
During the 1990s there was a substantial increase in the number of autonomous central
banks; many countries enacted legal reforms favoring central bank independence (table 1).
The evidence shows that the increase in central bank independence has been associated
with a reduction in inflation (Figure 1). This is valid for both developing and advanced
economies, and confirms the findings of a large body of research that includes more rigorous
statistical analysis to verify the robustness of the partial correlations. Also, higher degrees of
independence have helped to reduce inflation volatility. Therefore, autonomy is the adequate
strategy to correct the inflationary bias. In summary, the evidence indicates that higher
degrees of independence are associated with lower, more stable inflation and, hence, with
increased growth.
In Chile, over the twenty years of central bank autonomy, inflation has averaged 7.5% per
year. In the last decade, where inflation has been 3.2% on average, output volatility has
dropped markedly with respect to previous decades (Figure 2). These results suggest that
the conduct of monetary policy by an autonomous central bank has had a first-order effect on
our macroeconomic performance.
As for the inflationary process, the research findings are encouraging. The greater credibility
of the Central Bank regarding its inflationary objective, which is confirmed directly in the
market's inflationary expectations two years ahead, has reduced the well-known tradeoff
between inflation and growth.
The evidence shows that today inflation is better anchored in future inflation expectations.
Inflation looks less to the past and more to the target. This means that when shocks hit the
economy, the adjustments entail a smaller stabilization cost and, therefore, more output
stability, without jeopardizing the inflationary objective (Céspedes and Soto, 2007).
Proof of the importance of the central bank's autonomy and the associated gain in credibility
has to do with the capacity to implement countercyclical policies.
The stabilizing actions of an autonomous central bank allow it to confront negative shocks
without sacrificing credibility. A good example is the recent Chilean experience. The
substantial injection of liquidity and the subsequent sharp cut in interest rates as a response
to the international financial crisis of September 2008 occurred within a context where
inflation expectations over the policy horizon remained in line with the inflation target.
The empirical literature on the Chilean case provides evidence of a negative correlation
between the pass-through coefficient of nominal depreciations to inflation and the credibility
of the Central Bank. Said credibility is fundamental to allowing the real exchange rate to
contribute in the adjustments of the economy.
As for recent developments, the evidence shows that more autonomous central banks have
implemented more aggressive monetary expansions (Figure 3).
Conclusions
Twenty years into the era of autonomy of the Central Bank of Chile, we can say that it has
succeeded and it is consolidated.
There remain challenges ahead. The evolution of the economy in the past few years has
raised issues that need to be further analyzed to improve the policy framework.
An objective look at reality - acknowledging the personal conflicts of interests I have in acting
as an independent referee - shows that our country's current monetary policy has
succeeded as never before.
The business cycle has been smoothed and low inflation has been consolidated. Inflationary
expectations have stabilized and it is possible to implement a truly countercyclical monetary
policy. Of great support has been the accountable and predictable fiscal policy.
The successes in the conduct of monetary policy owe to the work of many people. Many
from outside the Bank have stressed the importance of its autonomy and its macroeconomic
achievements, and have also made strong contributions to improving the conduct of
monetary policy. This enables the consolidation of the institution.
Many from within the Central Bank have contributed decisively as well. Former Governors,
former and current Board members, as well as a great contingent of excellent economists
and professionals have contributed to the design of monetary policy, a better understanding
of our economy, and to administering an institution to which the country has entrusted great
responsibility and to which we have an enormous obligation of excellence.
Thank you very much.
Table 1
Evolution of the central banks' autonomy index and inflation (*)
I. Late 1980s
Autonomy index
Average inflation
(1989)
Economies Political Economic Total
Advanced 5.3% 0.39 0.59 0.48
Emerging 18.6% 0.27 0.38 0.32
Developing 22.5% 0.27 0.45 0.35
II. 2003
Average inflation
Autonomy index
Economies Political Economic Total
(1989)
Advanced 2.1% 0.74 0.81 0.77
Emerging 7.0% 0.47 0.75 0.61
Developing 8.4% 0.29 0.67 0.48
(*) Countries with annual inflation above 100% were deleted from the sample.
Sources: Arnone et al. (2007) and IMF.
Figure 1
Drop in inflation and change in the autonomy of the central banks*
-0.2 -0.1 0 0.2 0.4 0.6
-0.3
inflation
-0.5
in
drop -0.7
%
-0.9
-1.1
Change in independence index
(*) Drop in inflation corresponds to the percent variation of average inflation between
periods 1980-1989 and 2000-2008. Change in the independence index corresponds to
the change in Arnone et al. (2007)'s autonomy index between the late 1980s and 2003.
Sources: IMF and Arnone et al. (2007)
Figure 2
Growth volatility in Chile, 1911-2010 (*)
(Standard deviation of the growth rate)
18%
15.0%
15%
12.0%
11.5%
12%
9%
7.5%
7.3%
6.9%
5.1%
6%
3.6%
2.9%
2.2%
3%
0%
19111920 19211930 19311940 19411950 19511960 19611970 19711980 19811990 19912000 20012010
(*) 2009-2010 based on the IPoM of September 2009.
Source: Central Bank of Chile.
Figure 3
Percentage drop in the MPR between September 2008 and September
2009 and Central Bank independence
1.0
-
0.9
0.8
0.7
(09.2008 0.6
0.5
MPR
09.2009) 0.4
in
0.3
drop 0.2
%
0.1
0.0
0.2 0.4 0.6 0.8 1.0
CBC independent index (Arnone et al. , 2007)
Sources: Arnone et al. (2007) and Bloomberg.
References
Arnone, M., B.J. Laurens, J.F. Segalotto, and M. Sommer (2007), "Central Bank Autonomy:
Lessons from Global Trends," Working Paper 07/88, International Monetary Fund.
Barro, R. (1995), "Inflation and Economic Growth," Bank of England Quarterly Bulletin, 35,
pp. 166-176.
Céspedes, L.F. and C. Soto (2007), "Credibility and Inflation Targeting in Chile," in F. Mishkin
and K. Schmidt-Hebbel, eds., Monetary Policy under Inflation Targeting, Vol. XI, Central
Banking, Analysis, and Economic Policy series, Central Bank of Chile.
De Gregorio, J. (1995), "Inflación, Crecimiento y los Bancos Centrales: Teoría y Evidencia,"
in M. Aparacio and W. Easterly, eds., Crecimiento Económico, Teoría, Instituciones y
Experiencia Internacional, World Bank and Banco de la República de Colombia.