Federico Sturzenegger, Governor of the BCRA, participated in the Monetary Policy, Inflation and Growth panel, on Thursday, September 29, in the framework of the Annual Conference organized by the Latin American Economic Research Foundation (Fundación de Investigaciones Económicas Latinoamericanas, FIEL).
The full speech is as follows:
“Good afternoon. Thank you very much for your kind invitation. It is a great pleasure to be here once again and partake in this meeting with so many friends and colleagues. General opinion seems to be that countries can be grouped into those looking back into their history or those ready to envisage their future. I personally think that Argentina has spent too much time remembering. It is time now to change the focus and start envisioning the destiny of our country. And that is what I want you to do right now; I invite you to conjure up the picture of an Argentina without inflation. It is widely known that substantial progress has been made in fighting inflation in recent months. For the sake of argument, let us take the evolution of the CPI for the City of Buenos Aires where numbers speak for themselves: 6% in April (as a result of increases in utility bills which have been frozen for more than a decade), 5% in May, 3% in June, 2% in July and 0.9% in August (in fact, the August figure was -0.8%, which can be explained by a reversal in the price of gas, but as the latter will probably change again in the coming months, I consider it appropriate to disregard these effects for the time being). However, this progress does not mean that the battle has been won. In order to achieve a low inflation rate of 5% for 2019, we should actually be aware that the battle against inflation has just begun. This afternoon I would like to draw your attention to two key issues related to the fight against inflation. First of all, I would like to discuss why it is important to lower inflation— and we will see that the answer to this question can be split into two aspects. On the one hand, the positive impact on the reduction of inflation over economic growth; and, on the other, the fact that a drop in inflation is vital to reduce the levels of inequality existing in Argentina’s income distribution. Inflation tax is not only the most distorting and damaging tax, but also the most unfair and regressive one (as Lenin said: “the best way to destroy the capitalist system is to debauch the currency”). And lastly, I would like to analyze whether lowering inflation entails any costs, and which role do these potential costs, if any, play over time in terms of the benefits society derives from price stability. Before delving into the analysis, let me advance the answer to this particular question. To begin with, I would like to quote Borges’s famous story: “I have noticed that in spite of religion, …Jews, Christians and Muslims all profess belief in immortality, but the veneration paid to the first century of life is proof that they truly believed only in those hundred years, for they destine all the rest, throughout eternity, to rewarding or punishing what one did when alive.” This analogy, leaving philosophic differences aside (forgive me Borges), may be applied to the challenge of reducing inflation. If we only believed in the present, or if we were unable to see a horizon beyond a couple of quarters, we would commit the future, the life quality of our children, grandchildren, and great-grandchildren by giving up the fight against inflation. Let us now deal with the first question. Why is it important to have a low inflation rate, like in the rest of the world? To answer this question I would like to go over a couple of stories. The first one is that of the State of Israel which, since its creation in 1948, has undergone three distinct phases of development. Until 1970, it grew at quite a high pace. We may refer to that time as the colonizing period, where everything was achieved out of commitment, effort, asceticism and hope. Since 1970 Israel has uninterruptedly experienced inflation rates of more than two digits over the following two decades. The worst years being those of the first half of the 1980s, when inflation was well over 100% per year, reaching levels of 400% in 1984 and 1985. During the years of price instability, the economic growth rate was halved, economy experiencing several years of stagnation and even economic contraction. It was a period of confusion and anxiety, where questions and doubts prevailed. During that period, several of Israel’s Prime Ministers resigned before ending their mandates. Political instability was followed by financial instability. In 1983 Israel faced a banking crisis that led the government to nationalize the four largest banks in the aftermath of the collapse of their stock market shares. As a result of the measures taken by the Bank of Israel, inflation started to decrease rapidly in the early 1990s. They promptly left extreme inflation behind, reaching down to a 15-20% range between 1986 and 1990. But they struck a second (and final) blow to inflation from 1990 to 1992. Since 1997 inflation in Israel has not exceeded the one digit threshold, averaging 2.6% per year. Paradoxically, over the past three years, Israel has been dealing with an inflation rate that is below its 2% annual target. A few days ago at the BCRA Money and Banking Conference, the Governor of the Bank of Israel, Karnit Flug, told that if someone had told her 10 or 15 years ago that keeping inflation below the target would be a problem for the Bank of Israel in the near future, it would have been hard for her to imagine such a thing. “And yet, here we are now,” she told me. That may well be the case of Argentina in a few years. Just imagine for a moment that Argentina’s inflation target is 5% per year, and the BCRA’s difficulty in reaching such target lays precisely in an inflation rate that is even lower. However, it is interesting to find out what happened to Israel’s economic growth when its economy stabilized. As you may probably know, during that period Israel went through a process of vigorous growth—its GDP increased during the 1990s by an average of 5.8% per year—with a private sector characterized for its dynamism, technological advances and international market presence. It was a period full of bold and successful ventures that turned Israel into the famous “Start-Up Nation.” Israel has the highest percentage of population and GDP channeled to research and development in the world. In a short time, Israel became the second country in the world to have more companies listed on Nasdaq, even if compared to China, Europe and India altogether. Since inflation dropped, the size of the Israelite economy grew threefold, and its employment rate increased more than 11 percentage points. In short, Israel became a developed country. I would also like to make reference to the story of Chile and Peru, two neighbor countries that also suffered from severe inflation. During the 1980s and early 1990s, Peru endured inflation rates in excess of 100%, and for three years it experienced hyperinflation, characterized by price increases that edged up more than 7,500% per year. In that period, its average economic growth rate was negative at 0.7% per year. This decline was accompanied by higher levels of poverty (and by the Shining Path—Sendero Luminoso). During all those years in which Peru suffered such galloping inflation, its economy contracted on average almost 1% per year, and its per capita production shrank by 29% between 1980 and 1992. In twelve years, people in Peru lost 30% of their real income. It was only in 1994 when Peru managed to control its inflation levels, ending the year with a price increase of 15%. As from 1997, its average inflation rate has been 3% per year. Even though Peru had been suffering from high inflation, it soon achieved an inflation rate which was fully in line with the international standard. Thus, what once seemed to be impossible became a reality in a few years. And why not picture that for Argentina? Now, how has Peru’s economic growth evolved? Between 1993 and 1997 Peru’s annual inflation rate fell from 39.5% down to 6.5%, average growth was no less and no more than 7.2% per year, and per capita income increased by 24% (5.6% per year on average). Once inflation could be kept at low and stable levels, Peru’s GDP per capita grew by 70% between 1997 and 2015, an average of 3% per year. The change undergone, and progress made, by Peru is an everyday fact so much so that it has been called the “American Tiger.” In these years, Peru has been developing its agricultural, mining and energy potential. In terms of services, it has caused the tourism industry to flourish, in particular, the gastronomy sector, which made a leap of quality, becoming acknowledged as a high standard at a global level. The Peruvian government resorts to self-financing in soles (its domestic currency) with bonds at 40 years and 6.56% rate. Moreover, it has made early payments on its debt in dollars by issuing debt in soles, thus obtaining a more convenient rate. Some Peruvian companies are funded in soles with bonds at 10 years and rates around 6.5% to 6.75%. And why not picture that for Argentina? Imagine what would lie ahead of us if we were determined to fight a final battle against inflation. Price stability brings certainty to all players in society and becomes an incentive for them to embark on longer-term contractual agreements. With a reduced rate of inflation over the past few months, Argentina has been recovering an interest curve in pesos, which now covers a two-year span. I am sure the curve will continue to grow more and more, as we consolidate a low inflation rate. Time spans can, in fact, surprise us. Last Monday, Guillermo Ortiz told us at the BCRA Money and Banking Conference that Mexico took five years after the Tequila Crisis to issue a 3-year bond in pesos. That first issue yielded 18% per year. He added that, soon after, as the Bank of Mexico consolidated its anti-inflationary policies, rates collapsed and maturities quickly lengthened. I insist on saying that time spans may surprise us because it took us five months—rather than five years—to start forming a curve in pesos (with a two-year span). As of today 2-year Treasury Bonds in pesos yield a nominal interest rate barely above 20%, which means that confidence in the peso is increasing. The BCRA is committed to avoiding wages from being affected by inflation. Such commitment expands to safeguard all those who have confidence in the peso, not only in the short term, but also in the long run. Likewise, the BCRA moves in the same direction with all those who accept a fixed nominal return in pesos with a maturity of 2 years which may soon turn into three, five and even more years. Now, I would like to move on to the third example. Chile is another empirical proof of economic growth, which was made possible through the control of price instability. Since 1994, the Chilean economy has achieved a one-digit inflation rate after decades of high inflation. Since then, its average inflation rate has been 3.9% per year. For the first time, in 1990, the Central Bank of Chile set an explicit inflation target. It was not actually an Inflation Targeting Regime because at that time such schemes were germinal. However, it could be deemed as a precedent. Thanks to this type of institutional policy, the Chilean government managed to constantly lower their inflation rate from 27% in 1990 to 9% in 1994, and then, albeit at a slower pace, down to 4.7% per year in 1998. But the question remains… what happened to their economic activity in those years? Their economy grew by 7.5% per year on average, per capita income increased by 57% on a cumulative basis, i.e. 5.8% per year on average. And if we focused ourselves on such years when the inflation rate dropped faster (1990-1994), we would conclude that Chile’s economic growth was 8.2% per year. Disinflation was that expansive! Since then inflation has stabilized around 3%, and its GDP grew by an average rate of 4% per year, accumulating a 58% real per capita growth (an average of 2.6% per year). In this period, Chile has cut its poverty to a third and its housing deficit plummet. In 1990, its PPP per capita income was 20% lower than Argentina’s, and today it is 14% higher than ours. Imagine that Chile’s scenario may play out in Argentina. Growth, equity and credit are the pillars of a direct and final combat against inflation. I invite you to look ahead and see beyond the very short term. In case these lessons were not enough, we can mention our own case. The worst economic period in the history of Argentina spanned from 1975 to 1990. During such period, average inflation was 820% per year (14% per month, based on the average of monthly price changes) and GDP per capita growth was -1.5% per year on average. Every year Argentines lost 1.5% of their real income. On a cumulative basis, Argentines lost 21% of their income over 15 years. In the book I wrote a few years ago, titled I do not want to leave, I claim that the hypothesis of Argentina’s secular stagnation is false, and Argentina’s backward economy may only be explained in terms of that 15-year period. Let me explain this with another example. In 1975 Argentines earned 50% compared to Americans, something below the ratio at the beginning of the century (more or less between 60% and 70%). But from 1975 through 1990 the relative income fell down to a half (28%). The 1990s were characterized by lower inflation levels. Between 1991 and 2010 the average inflation rate was 10% per year, which boosted positive growth—in spite of the convertibility crisis. The growth rate jumped to 3.6% per year and 2.6% per capita on average. By the end of this period, Argentines earned 39% compared to Americans did, thus recovering some of the lost ground. However, between 2011 and 2015 the average inflation rate rose to 29% per year, which immediately triggered, again, a stagnation of the economy. During those four years, GDP per capita (according to new reliable INDEC statistics) fell by 3.4% on a cumulative basis. The point I am trying to underscore is that the benefit of defeating inflation outweighs any effort that has to be made to achieve such target. Nobody can doubt that historical growth experiences are diverse as the reasons lying behind economic growth. It is impossible to think of the growth of Israel, leaving aside the fact that after the dissolution of the Soviet Union scientists migrated on a massive scale to Israel; or that the growth of Peru occurred when they succeeded in placing their products in the North American’s market and winning the battle against terrorism. All in all, the correlation between success against inflation and a process of healthy growth cannot be denied. This Monday we set the Inflation Targeting Regime in Argentina, thus crystallizing all the work we have been doing to fight against inflation since the start of our administration. This institutional scheme is somewhat new to Argentina’s history. In a nutshell, it signals an independent BCRA that sets inflation targets and uses all the instruments it has at reach to achieve its target. Thus, monetary policy will not adjust to inflation expectations, but will ensure that the expectations and actions of players are consistent with the BCRA’s targets. You may well wonder why this scheme to control inflation has been successful around the world. Price level is nothing but the representation of the price of money. If there is more money than the amount people want, money price will fall or, in other words, the price of goods will rise (relating to money). This phenomenon is called inflation. That is, whenever the amount of money supplied is larger than that demanded (either because supply increases or demand decreases) we will be faced with inflation. Therefore, fight inflation calls for a scheme where money demand and money supply are brought into balance. Upon the consistent implementation of an institutional schedule aimed at balancing the domestic monetary market, the “engines” that give rise to inflation come to a halt. Thus, a schedule with these characteristics that matches monetary offer and demand will enable inflation rate to fall dramatically in Argentina. The year 2016 was very special because we had to take the first steps in the absence of an index as a target. Shortly after the INDEC published the index of consumer prices for the metropolitan area, we established this year’s inflation target at 1.5% or less per month for the last quarter. On past Monday we ratified that our inflation target is going to range from 12 through 17% between ends of months for the year 2017. In last December, when we started working to achieve this target, that 1.5% per month target was viewed with certain skepticism. Surprisingly, it was achieved two months in advance. This result has brought some credibility as to the task we are to fulfill in the future. Last Tuesday, the BCRA decided to keep its rates unchanged. Now, we are working to consolidate the disinflation process, while analyzing next year’s expectations. The BCRA has the necessary resources to make inflation meet its target. Work will continue to be complex and the tools used may certainly not be perfect, but rest assured that the monetary authority has the expertise and the resources needed to achieve its mission, as it is already known worldwide. Our task only involves the communication of our targets and their subsequent compliance. This allows social players to learn about the range within which others may change their prices (on average, of course), which provides predictability and peace of mind for making decisions. For example, such decisions about prices as were adopted during the first half of the year were not entirely in line with the BCRA’s disinflation targets. As companies became aware of the lack of correlation between their prices and the policies of disinflation implemented by the monetary authority, a wide variety of discounts began to pop up, thus internalizing the effect of the BCRA’s monetary policies. In these months, some sectors started to adjust to the new regime. A good example is the automotive sector, which made its prices compatible with current monetary policy, generating a significant leap in sales. Other sectors are also following this trend, thus exerting the same effect on their sales and activities. However, I must admit that others do not seem to have taken note of the changes (such as prepaid medical care or drugs, for example). In any case, it is only natural for expectations and decisions to meet on a gradual basis for they involve a process that consolidates over time. What I mean is that we have not merely set clear targets; rather we deeply believe in the fact that our economy will greatly benefit from solving this problem for once and for all. Nevertheless, there is another reason to fight inflation: the devastating effect of inflation on income distribution. The Argentine tax system has proved to be regressive, not progressive over time. But within such an already regressive structure, the inflationary tax is the most regressive of all and the most harmful for low-income sectors. According to recent empirical studies conducted in Argentina, the inflationary tax stands for 21% of the income for a family of the lowest income decile, while it means less than 3% for a family of the highest decile. The incidence of the inflationary tax distribution is absolutely regressive, and the effect exerted upon the extremes of national income distribution ends up being dramatically different. This is another, and even more essential and urgent, reason why the reduction of inflation is a must. Thus, if the first reason (growth) is not enough to account for the need to fight against inflation, the redistributive effect of inflation certainly is. The truth is that the achievement of growth with social equity could not find a better way than the reduction of the rate of inflation. So I think the whole debate over the short-term costs of lowering inflation should be relegated to second place. It is clear that the benefits far outweigh the costs. But this does not mean that we cannot take a couple of minutes to analyze whether these costs actually exist and, if so, their characteristics. We have often heard that the recent decline in inflation is the result of a recession (although, to be honest, the recession had begun last year, long before we started with our anti-inflation policy). Economists often like to refer to the “Phillips Curve” as a way of explaining this concept. One of its versions states that there is an inverse relationship between unemployment and inflation rates. Stated simply, more growth would bring about decreased unemployment which, in turn, would correlate with higher rates of inflation. The truth is that in Argentina this relationship has not been actually verified. I invite you to focus on the Phillips Curve in Argentina. Let’s look at a couple of graphs that simply show the per capita economic growth in Argentina over several years (on the horizontal axis) and the inflation rate in the same period (on the vertical axis).
You will see that dot concentrations are not meaningful, and the slope of the curve tends to be negative at times (which would imply a Phillips Curve with a positive slope). We could say that the years of lower growth in Argentina were not accompanied by low inflation and vice versa. The graph seemingly shows that the years of higher inflation entail the worst economic performance. While the Phillips curve may make sense in economies with a history of stability, like developed countries, it is naturally not relevant in the Argentine context. However, the graph shows that this situation may be exactly the other way around. It is the decline in inflation that is associated with recovery and economic growth. Let us put that argument aside and move on to another line of thought that is frequently shared, especially by those who challenge the 12%-17% inflation target for the coming year. According to the latter, Argentina suffers from a strong “inflationary inertia.” That is to say, a process of inflation caused by factors beyond the money market, such as expectations of rebel inflation or wage negotiations, which entail backwardness and, consequently, cause the inflationary process to continue rather than to halt. Thus, the famous “inflationary inertia” has been at the core of many debates on inflation in Argentina. During the 1980s, inflationary inertia implied that past inflation was a major determinant of subsequent inflation, so the inflationary process persisted, regardless of the monetary policy followed. At that time, there was a real “contractual inertia.” That is to say, most of the contracts were legally adjusted in terms of past inflation, which made any disinflation process very complex. Fortunately, we’ve learned the lesson, and since the introduction of the Convertibility Plan, this type of adjustment no longer exists in Argentina, so we do not have to deal with this phenomenon at the present time. In fact, Argentina stuck to this idea to such an extent that the previous administration detached from indexation, and prices soared tenfold. It is worth mentioning that many countries that underwent disinflation in the 1980s and 1990s had to deal with this type of contractual adjustment in prices. Sometimes people ask me why our disinflation process will take four years when Colombia took many more years. But it cannot be ignored that Colombia was forced by law to adjust their prices based on past inflation, generating instability with strong deviations of relative prices from their equilibrium values during the disinflation process. In fact, the potential “inflationary inertia” mentioned by analysts today could be explained by analyzing agents’ expectations, just as explained by the Barro-Gordon model. According to this model, if a Central Bank indulges in short-term commitments, then this temptation may be forecast by such agents as create expectations accordingly. Hence, inflation expectations should be high enough to dissuade a Central Bank from any expansive attempts, or, in other words, inflation with stagnation. At this juncture, the relevance of an Inflation Target Regime comes into play, particularly in order to break with this type of inertia, and to contribute towards the disinflation process. Within this framework such regime requires an independent Central Bank, and long-term targets which should not be deviated by short-term shortcuts. Once a Central Bank has gained credibility for the achievement of its long-term targets, it will be able to align agents’ expectations with future inflation targets. The Inflation Target Regime is the institutional scheme that allows breaking the type of inflationary inertia described in the Barro-Gordon model, the only one present in Argentina today. We could say that the BCRA has been successful in aligning expectations. The latest Market Expectations Survey (Relevamiento de Expectativas de Mercado, REM) shows that analysts’ expectations are quite in line with the BCRA’s targets for this year, and even not far from the target for the coming year. Therefore, we consider that the Inflation Target Regime is an effective tool to align agent’s expectations and put an end to the inertia as under the Barro-Gordon model. As published in the latest REM, carried out at the end of August, analysts expect a core inflation of 1.6 %, 1.5% and 1.5% in October, November and December, respectively—by setting aside the expected index volatility arising from rate changes (deflationary in August and September), and adding the expected inflation in the subsequent months. This implies that the BCRA’s inflation target (of 1.5% or less per month for the last quarter, generally speaking) is about to be utterly reliable for the remainder of 2016. Inflation expectations for next year stand at 19.8%, and in the case of core inflation at 17.9%. As the target announced by the BCRA ranges from 12% to 17% for 2017, we still have a ´credibility gap´ of virtually 3 p.p. in relation to the 17% cap. The BCRA has already been adopting monetary policy measures to eliminate that gap. In short, the BCRA understands how important it is for our country to defeat inflation once and for all. We are called to look beyond current scenario and bear in mind that staying halfway, with moderate inflation, is hardly the way ahead; we need to keep down inflation below 5% per year. It is a must to achieve such a target so that our country may fully develop with social equity. The battle against inflation has just begun. To recap, the BCRA has all the necessary tools at hand and is carrying out its mission in a context of great independence. We do not appeal to voluntarism. Rather we merely release information about our next steps. Hence, predictability on our part together with a free background for you to adopt informed decisions is exactly what will drive Argentina out of inflation. Argentina will ultimately be a country marked by stability, growth and social justice.”
