José De Gregorio: Monetary policy and financial stability - an emerging
markets perspective
Presentation by Mr José De Gregorio, Governor of the Central Bank of Chile, at the
Brookings Institution, Washington DC, 17 September 2009.
* * *
It is a pleasure to participate in this meeting and to speak about the lessons for monetary
policy the current crisis is teaching us. The big difference between the current crisis with
previous ones in emerging economies is that this time "it was not our fault." The evidence on
the performance of emerging countries facing an unprecedented global downturn shows that
some lessons have been properly learned.
Today I would like to concentrate on inflation targets, especially in the context of strongly
rising and strongly falling commodity prices, financial stability and exchange rate fluctuations.
Many of the issues I will be discussing today I have covered in recent presentations
elsewhere. Indeed, there is not much new material, but I think those are important issues in
conducting monetary policy in emerging countries.
1. The causes of the crisis: was it monetary policy or was it financial fragility?
The argument blaming monetary policy for the current crisis claims that low interest rates
combined with large current account surpluses in emerging economies, particularly Asian
and oil-exporting ones, created an abundance of liquidity that triggered excessive increases
in asset prices (bubbles). This was particularly acute in the housing market. When the bubble
burst, the crisis erupted. Then, this argument claims that the housing bubble was caused by
monetary policy, which failed to act opportunely and permitted severe imbalances to
accumulate. Nonetheless, one must bear in mind that soaring asset prices do not necessarily
end up in a crisis like this one. Closer attention must be paid to the financial fragility that
accompanied this process, whose main culprit was the unrestrained financial innovation that
generated deep distortions that neither markets nor regulators were able to predict.
An expansionary monetary policy can undoubtedly induce an excessive increase in the
prices of assets and credit. The ultimate role of monetary policy is to smooth the business
cycle and control inflation.1 Therefore, it is possible to think that a very expansionary
monetary policy, more so than that needed to reach the inflation target, can exacerbate an
economic boom. Moreover, such a policy will have serious consequences on output once the
monetary impulse is withdrawn. However, an expansionary monetary policy could not explain
by itself the severity of the financial collapse and the global recession the world is seeing
today.
There are countries where monetary policy was expansionary, with interest rates at their
minimum, and no housing bubble nor financial collapses occurred. A couple of examples are
Canada and Chile, two inflation targeters where, consistently with this policy framework,
interest rates hit very low levels not so different from the Fed Funds rate (Figure 1). Still,
housing prices generally did not experience increases comparable with those of other
economies, and their financial systems have remained sound.
Furthermore, in some cases housing prices did go up high, with clear indications that there
was a bubble. However, their financial systems made it through and remained stable and,
despite the current difficulties, have avoided acute financial crises. This is the case of, for
example, Australia and Spain. Naturally, when facing disproportionate increases in housing
prices, both the increase in credit and the boom in construction are symptoms that the
downturn will be severe. Still, this need not result in a systemic financial meltdown.
In any case, monetary policy can and does help in the creation of bubbles, although not so
much by the level of the interest rate but by the monetary policy strategy with which financial
turmoil is dealt with. In the United States, the strategy of turning a blind eye to the period of
soaring asset prices and then, when the bubble burst, reducing aggressively interest rates
used to be the Fed's strategy (the "mop-up strategy" according to Blinder and Reis, 2005).
This approach was first used on the "Black Monday" of October 1987, then with the
breakdown of Long-Term Capital Management (LTCM) and later with the bursting of the
high-tech bubble. In all these occasions, once the asset prices reversed down, there was an
abrupt relaxation of the monetary policy.2 This implicit insurance, popularly known as the
Greenspan put, certainly makes the creation of bubbles more likely. This strategy, which
worked in some earlier episodes, failed miserably during the biggest collapse in decades. A
monetary policy strategy that used to provide insurance to speculation in episodes of limited
financial turbulence proved incapable of confronting a financial crisis of systemic proportions.
This strategy to deal with bubbles is a prescription derived not from inflation targeting, but
from a need to insure financial stability. In my view, financial stability must be addressed first
with appropriate regulation of the financial system that limits the excesses we saw before the
crisis. There may be situations in which it might be appropriate to deviate transitorily from an
inflation targeting regime in order to ensure financial stability, but this must be an exception,
which in normal times should not arise. I think a first lesson for the conduct of monetary
policy is to avoid providing insurance to speculators, which creates enormous moral hazard
problems. In emerging countries we have lived this, with much milder consequences, when
we attempted to manage exchange rates disconnected from fundamentals for a prolonged
period of time.
Therefore, an examination of monetary policy and financial dislocations around the world
suggests that the culprit of the current crisis was related more closely with the functioning of
financial systems than with monetary policy. One issue that will have to be carefully
examined in the future is the cause of the real estate boom and the housing crisis, and why it
occurred in the United States. At this point it is clear that lending standards were relaxed
beyond reason, and financial innovation went too far.3
2. Inflation targeting and asset prices
A corollary of those blaming monetary policy is that, apart from focusing on the variation of
the prices of goods and services, it should also take into consideration asset prices, beyond
their direct impact on projected inflation.
Under an inflation targeting regime, increased lending and asset prices can have
repercussions on the inflation outlook, through their impact on the output gap. This would
require a monetary policy adjustment to prevent a persistent rise in inflation. Hence, in an
inflation targeting regime, asset prices and the level of credit aggregates affect the monetary
policy decision to the extent that they affect the inflation perspectives (Bernanke and Gertler,
1999).
However, some will argue that monetary policy should react directly to asset prices, for
example, by including them in the Taylor rule. Cecchetti et al. (2000) are perhaps the best
representatives of this position, claiming that any inflation-targeting central bank should react
to asset price misalignments beyond their implications on expected inflation over the policy
horizon.
In my view, there are three reasons why monetary policy, in general, should not react to
asset prices beyond their impact on projected inflation:
•
First, 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.
•
Second, what matters here is to safeguard the stability of the financial system. An
excessive interest rate aiming at controlling asset prices could even trigger financial
instability, which is precisely what it is meant to avoid, especially if the increase in
asset prices is accompanied by higher financial fragility.
• Finally, under inflation targeting, any interest rate movements that are inconsistent
with inflation converging to the target may undermine the credibility of monetary
policy, destabilizing inflationary expectations, and weakening the effectiveness of
monetary policy. This is particularly important in the case of emerging economies with
a shorter record of monetary stability.
Another reason that has been put forward to not try to affect asset prices through monetary
policy is simply that it is impossible to determine when prices are significantly misaligned with
their fundamentals. Although I agree with the fact, I do not think this is a strong reason.
Indeed, even though it is difficult to determine when prices are fundamentally misaligned,
policymakers should worry about this phenomenon. However, acting through monetary policy
may not be the best option, and it is better to look more closely at financial regulation and
how to limit the procyclicality of the banking system and build enough cushions for the
downturn. This should also reduce fragilities that are generated during the upturn.
3. Inflation targets, exchange rates and intervention
An inflation-targeting regime, where the policy instrument is the interest rate, must operate
within a context of a flexible exchange rate. This solves efficiently and unambiguously the
well-known impossible trinity for countries financially open, and allows the control of interest
rates at a level consistent with the inflationary objective. Adding an exchange rate objective
weakens the capacity to control the interest rate, affecting the ability to meet the inflation
target.
However, the exchange rate generally has effects on monetary policy, since persistent
movements of it do affect inflation. In this case, the natural result is a leaning against the
wind. When the exchange rate appreciates substantially, it prompts a fall in inflation in the
medium term, which results in a reduction in the interest rate. This, in turn, induces pressures
for depreciation. However, one must recognize that these are not very significant effects
because, in a floating regime, the pass-through coefficient from the exchange rate to inflation
is limited.4
Emerging economies may feel tempted, after a long history of crises caused by exchange
rate misalignments, to keep their currencies depreciated. Managing the exchange rate is,
apart from hardly feasible in the medium to long term, risky. In the first place, in less flexible
exchange rate regimes, the pass-through from exchange rates to inflation increases,
because the level of the exchange rate may become a coordinator of price expectations,
given the policymakers' commitment to exchange rate stability. This, in turn, feeds back to
increased pressures to keep the exchange rate stable, thus aggravating the problem.
Secondly, a commitment of the authority with exchange rate stability may create perverse
incentives to financial risk taking, by artificially lowering the cost of borrowing abroad. This
reinforces fear of floating (Calvo and Reinhart, 2002), creating a spiral towards exchange
rate rigidity, and deriving in currency mismatches and exchange rate misalignments that the
policies were intended to prevent in the first place.
I am not saying that attention must not be paid to the exchange rate beyond its effects on
inflation. The exchange rate is an important determinant of resource allocation, and hence,
excessive deviations from fundamentals may create distortions. However, I think a sensible
way to address signs of severe misalignments, beyond the leaning against the wind with
monetary policy, is through sterilized intervention. But, in order for this to be effective and
coherent with the inflation targeting framework, some conditions must be met:
•
In the first place, it must be consistent with the inflation target, in order for the
intervention not to jeopardize the credibility of monetary policy.
•
Secondly, to safeguard monetary policy independence, once the intervention is
announced, it must be implemented mechanically. All this shields the conduct of
monetary policy, typically carried out in regular pre-established meetings, from the
extraordinary decision of buying or not buying foreign currency. In particular, the
sterilization of intervention decisions permits to preserve both the credibility and the
independent management of monetary policy.
•
Finally, and because of this sterilization requisite, the cost of intervention must be
properly considered, because it entails a quasi-fiscal component that could be
significant.
The Chilean experience last year was in line with the aforesaid principles. It was done in a
moment where there was clear evidence of misalignment with respect to the levels deemed
consistent with long-term fundamentals. It was also totally consistent with the inflation
objective, and started at a moment - April 2008 - in which there were rather benign inflation
figures that revealed a smaller risk of unwanted inflationary propagation. Towards midyear it
was even possible to raise the interest rate substantially to tackle a surprise rise in inflation
that was much deviated from the target. This was so thanks to the fact that the purchase of
dollars was being carried out mechanically, despite a significantly depreciated exchange rate
after the intervention. The purchase of foreign currency was concluded prematurely due to
global tensions in global liquidity in dollars in September of last year. The capacity of the
Chilean economy to subsequently deal with a significant exchange rate depreciation, with
monetary easing prospects and reduced inflationary pressures, is proof that there was no
inconsistency between the decision to intervene and the conduct of monetary policy (Figure
2). It also shows that the flexible exchange rate regime adopted early this decade has the
economy well prepared to absorb exchange rate fluctuations without the turmoil that used to
come with them in the past.
4. Bubbles, exchange rates and capital inflows in emerging economies
Latin America went through a period of large capital inflows in the first part of the 1990s
(Calvo et al., 1996). We cannot disregard the possibility that after the current crisis is over,
there will be a reemergence of inflows to emerging economies. Therefore, there could be
strong pressures for a sharp increase in the valuation of domestic assets, with a potential
bubble in their prices, and this bubble could take the form of an exchange rate appreciation.
To begin this discussion, I should emphasize that capital inflows to capital-scarce economies
are a good thing. We know that capital flows to institutionally strong economies are beneficial
(Prasad et al., 2002). Therefore, the role of policy is not to impede capital flows, but to avoid
the creation of a bubble in domestic assets with consequences on resource allocation.5 In
this regard, to have in place sound prudential regulation during periods of abundance of
capital is essential for financial stability, as we are reminded by the crisis in Chile in the early
1980s, the Mexican crisis of the mid-1990s, the Asian crisis, and more recently, the crisis in
Eastern Europe.
Even if one could accept that monetary tightening could be an appropriate response to
combat an asset price bubble such as the recent housing price bubble, with all the caveats I
discussed before, the problem is more acute in small open economies. Tightening monetary
policy may have perverse effects, since it induces further capital inflows and strengthens the
currency. In this case, the interest rate is not the most adequate instrument with which to
burst the bubble.
Indeed, the perverse dynamics are as follows: high interest rate differentials induce capital
inflows to arbitrage those differences; then policymakers strive to avoid the appreciation,
which in general is thought to be transitory, since the sustainability of exchange rate
management is limited; the incentives for inflows increase as not only the interest rate
differential is large, but also the expectations of appreciation; finally, the appreciation takes
place, which validates the expectations of arbitrageurs. This process goes for a while and
may be accommodated gradually or ended by a sudden stop. In this process there are
"excess" inflows and "excess appreciation", and the issue is how to avoid those excesses.
According to the simple dynamics I have just described a first line of defense to avoid excess
fluctuations of capital flows is to maintain exchange rate flexibility. This prevents investors
from speculating against an authority that will be defending the parity only transitorily.
Moreover, by introducing volatility it increases the risks of a one sided bet on the exchange
rate.
An inflation commitment may also help to stabilize flows. As I discussed before, massive
inflows that appreciate the currencies will result in a loosening of monetary policy that should
reduce the incentives for carry trade. In contrast, if capital inflows generate a boom of
activity, without inflationary consequences due to the appreciation of the currency, there
could be the temptation to tighten monetary policy, aggravating the problem of massive
inflows. To control expenditure without increasing pressures on the exchange rate, fiscal
policy should help.
A credible inflation target with a flexible exchange rate regime should help to avoid the
problems we faced during the 1990s. Indeed, during the period of large capital inflows, no
monetary policy in Latin America operated under a full-fledge inflation targeting regime, and
most countries had some form of exchange rate rigidity.
Despite having a flexible exchange rate and an inflation target in place, the effects on the
exchange rate could reflect that domestic asset prices could be forming a bubble. In this
case, sterilized intervention, without an explicit objective on the level of exchange rate, can
also help. I already discussed some principles to guide sterilized intervention within an
inflation targeting framework. A much debated proposal is the use of capital controls. The
evidence on their effectiveness is elusive.6 Effectiveness is also severely impaired as
domestic financial markets have reached some degree of development and integration with
the rest of the world. With hindsight from the current crisis, one can think that rather than
controls, what is needed is a prudential regulatory framework to avoid speculation and high
risk taking in the banking system.
5. The rise and fall of inflation
In this section I will review inflation behavior in Chile, a country that had the sharpest
increase in inflation among emerging economies in the run up of commodity prices, but also
the largest decline since the crisis erupted (Figure 3). The most remarkable component of
the inflationary process of 2007-2008 was how strongly the increase in international food
prices was transmitted domestically. Inflation rose from a y-o-y rate of 2.6% in December
2006 to 9.9% in October 2008. Then, it declined to -1.0% in August 2009.
What accounts for the steep rise in inflation? It may partially be due to Chile's high degree of
commercial openness. There are practically no barriers to imports, no widespread protection
of agriculture, nor any large-scale distortions in the market pricing mechanism, so changes in
external prices are quickly reflected in the domestic market. In fact, at least during the
greater part of 2007, growing inflation was mostly caused by increasing food prices, rather
than by a widespread inflationary process (Figure 4).7
The 2007-2008 food price shock was partially considered to be a one-off change in global
relative demand and supply, such as the increased use of biofuels that should have no
severe medium-term inflationary implications. However, with inflation rising, the monetary
policy rate (MPR) was raised by 125 basis points in the second half of 2007, in order to
8
mitigate undesirable second-round effects of the supply shocks (Figure 5).
By early 2008, the inflationary situation was still a complex one, but risks had decreased, and
inflation was expected to reach its target thanks to the monetary policy actions already in
place, lower world growth and a strengthened peso. Trend inflation tempered and monetary
policy remained unchanged. During this period we decided to initiate a process of reserve
accumulation. Nevertheless, halfway through the second quarter of 2008, the inflation path
radically changed; the inflationary trend resumed, unexpectedly, with monthly inflation
reaching more than 1%. The risks of inflation remaining above the target beyond the policy
horizon also grew strongly. Consistently, monetary policy also had a strong reaction. The
MPR was increased by 200 basis points in just four months. By September 2008, before the
collapse of Lehman Brothers, the Central Bank estimated that it would be necessary to raise
the MPR further, even above market expectations.
Finally, inflation reached its 9.9% peak in October. It is still early to determine with a great
degree of certainty the strong and sudden propagation of foreign shocks on domestic
6
For a review of the Chilean experience, see Cowan and de Gregorio (2007). The only empirical study that
found some effects of reducing the extent of the appreciation is Edwards and Rigobon (2009), however the
magnitude of such effect is small, since the elimination of capital controls from its maximum would have
appreciated the exchange rate between 2 and 2.5%. In any case, it is useful to remind that the most
appreciated real exchange rate in the last 20 years in Chile occurred in 1997, year in which there were capital
controls, massive reserve accumulation, an exchange rate band and high interest rates.
7
Another factor underlying inflation pressures and a deceleration of growth was the higher cost of energy. Not
only had thermoelectric power plants to operate with more costly inputs, but also unfavorable hydrological
conditions and the shortage of natural gas implied that these more efficient sources of generation had to be
replaced by diesel.
8
For simulations on the monetary policy response to an oil shock see Desormeaux et al. (2009). They conclude
that the response should be moderated when the shock is transitory and policy is credible. A much stronger
response is suggested by Batini and Terenau (2009).
BIS Review 113/2009
inflation. Inflation propagated to most prices, so core inflation also increased sharply. The
output gap increased slightly during the third quarter,9 although domestic demand was
growing strongly (Figure 6). The exchange rate did not add significant inflationary pressures.
Perhaps, the sharp increase in oil prices - which came close to 150 dollars per barrel -
caused a generalized rise in domestic prices. A strong demand and a large cost shock may
have induced an unusual fraction of price-setters to adjust prices, despite the fact that the
output gap did not change significantly. However, if this had been the case, prices should
have remained more stable rather than experiencing a sharp fall after commodity prices
started falling.
As in most of the world economies, financial tensions were severe after the collapse of
Lehman Brothers. Interest rates in both peso and dollar markets posted substantial increases
in the most stressful times from mid-September to mid-October 2008 (Figure 7). The Central
Bank acted quickly, providing peso and dollar liquidity facilities to the financial system to
ensure resource availability would foreign loans become scarce. These facilities, which will
be in place throughout 2009, have not been used extensively by financial institutions,
reflecting their sustained access to external markets. This is an example of how monetary
policy can react to mitigate financial turbulences without affecting the path of monetary policy
considered to be consistent with the inflation target.
Beyond the stressful episodes in local money markets, the world financial crisis and its
aftermaths in the real sector have caused a significant drop in domestic demand and
economic activity. Lending standards have certainly tightened, but the Chilean economy is
far from suffering the problems that other countries are facing.
Accordingly, the inflation outlook changed significantly, while monetary policy reacted with a
change that was large in magnitude and swift in implementation. October 2008 was the
month where y-o-y inflation peaked. November brought some relief, largely determined by
the drop in fuel prices in world markets. By then, no break in the inflationary trend was
foreseen. Nonetheless, given the weakening outlook for activity and inflation, the Central
Bank not only did not raise the MPR - which was the most likely path of monetary policy as
discussed in September's Monetary Policy Report presented to Congress - but also
communicated that the most likely course of action would be an easing of policy by early
2009.
In January 2009, with a clearer assessment of the reduced inflationary pressures, the MPR
was lowered by 100 basis points. Later, with the evidence of alleviated inflationary pressures
and drastic increases in downward risks to growth and inflation, the Central Bank decided to
cut the MPR by 250 basis points at both its meetings of February and March. The monetary
easing process continued and completed 775 basis points in seven monthly meetings,
bringing the MPR to 0.50%, the minimum level deemed adequate for a normal functioning of
money markets. In addition, the Central Bank adopted some non-conventional monetary
policy measures, extending the overnight liquidity facility for banks at the MPR to 180 day
tenors and cutting the issuance of 1- and 2-year Central Bank bonds. It has been also
announced that the MPR will be held constant at this minimum level for a prolonged period of
time, and that it will use with flexibility all the monetary policy tools at hand, which goes way
beyond setting the MPR every month.
Several lessons and challenges arise for the Chilean experience. First, the volatility of
inflation has been very large. This could be explained by the severity of the shocks hitting the
economy, but this is not so clear when comparing with other countries. Although it was
argued that indexation could be resuming and inflation would stay high, the turnaround was
impressive, and hence, it is not clear how persistence has evolved, and it is difficult to
explain with a simple linear adjustment. It could be argued that the change in inflation is due
to the impact on inflation of the widening of the output gap. However, the output gap changed
little when inflation was rising, and the current decline cannot be explained by the current
narrowing of the output gap.10 We used to think that the output gap, as a proxy for marginal
cost, is what affects inflation, but the Chilean experience was more of a large swing in the
growth of domestic demand rather than output. However, the connection from domestic
demand to inflation is less clear than that of the output gap. Finally, the degree of openness
and competition in the Chilean economy may increase the sensitivity of prices to demand
conditions. More work would have to be done to fully understand the dynamics of inflation,
but still the inflation targeting framework has been very useful to conduct monetary policy
and to stabilize inflationary expectations.
6. Concluding remarks
Although more often than not, central banks have an explicit financial stability objective, for
many years, and within a context of strong GDP growth and sound balance sheets of banks
and firms, this was a second-class issue. Now things have changed dramatically. As of last
year, financial stability became the protagonist in monetary policy management in developed
countries.11
Central banks need to oversee price stability and financial stability. To pursue two objectives,
one instrument, namely the interest rate, is not enough. Indeed, a well functioning financial
system strengthens the transmission mechanism of monetary policy. There may be
exceptional occasions in which both objectives may collide, for example when monetary
policy requires an increase in the interest rate, while financial stability calls for a reduction.
Another example could be a bubble in the exchange rate with high inflation. In the context of
monetary policy in an inflation targeting regime, those situations could be accommodated by
escape clauses. But, more in general both objectives should be addressed with more than
one instrument.
The overall purpose of financial stability is to ensure the proper functioning of markets and to
avoid having to arrive at the degrees of turbulence and dislocation we have witnessed in the
past year. For this reason, financial regulation plays a major role in granting financial
integrity. At the beginning, regulation focused on the strength of individual institutions.
However, the tensions we have seen show how individual fragility may quickly evolve into
systemic problems. The interrelationships among financial institutions and the proper
operation of the markets where liquidity is traded are essential ingredients of a market
economy, but these characteristics are also the channels of financial contagion, as recently
seen. So it is crucial to have a systemic vision, not only from the perspective of how the
different institutions relate to each other, but also on how the different types of financial and
operating risks are intertwined, creating potential vulnerabilities.
Regarding price stability, conducting monetary policy within an inflation targeting scheme is
appropriate, and recent experience shows that it may provide ample room for expansionary
policies when facing a global recession such as the current one. There will be a long debate
and a number of research papers on the proper mechanism to secure financial stability and
how it should be combined with monetary policy management. However, the current
experience in many emerging markets is a demonstration that the objectives of financial
stability and price stability can be preserved even under extreme tensions.
In sum, conducting monetary policy through an inflation targeting regime, with flexible
exchange rate, clear mechanics for exceptional sterilized intervention only when there are
clear signs of misalignments, a countercyclical fiscal rule, and a strong financial regulatory
framework has worked quite well to mitigate the effects of the worst crisis the world has
faced in several decades.
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