Towards an Inflation Targeting Regime
By Lucas Llach, Deputy Governor of the BCRA.
In 1582, the western civilization started to use the Gregorian calendar, with a smart system of leap years (a leap year every four years; so year 2000 was a leap year, while years 1800 and 1900 were not because they are not divisible by 4). This calendar proved to be a success in measuring time and has been the most widely used at an international level until present. Almost two centuries later mankind worked out another issue of measurement: determination of longitude in any part of the globe, a much harder task than that of latitude. John Harrison, a Yorkshire carpenter, won, after 30 years of work, the award instituted by the British Crown in 1714. The decimal metric system is another popular measurement method that is also used nowadays. In 1791, the Marquis of Condorcet, idealistic supporter of the French Revolution, defined the metric system as a product ´for all people for all time´. Indeed, two centuries later it was adopted as the official system of weights and measures worldwide, except for United States, Liberia and Myanmar.
Date, location and measures, are essential elements to accurately define, for instance, the terms of a sales contract of a country property. It is then vital to determine the location and size of the real estate, and the dates in which the contract should be executed and paid. The only quantitative element missing here is the amount to be paid. The way to determine a clear unit of value has remained controversial worldwide. For centuries, different metals were taken as a standard.Yet this system was rather inadequate since a rise in the price of gold, in connection with the price of the other assets, would trigger an event of deflation, i.e. fewer coins for the same pair of shoes. Paper money enabled to detach the nominal price of goods from the relative price of metals and goods. However, paper money also brought about inflation and, at times, deflation. It has only been in the past 30 years that most of the countries in the world managed to achieve a relatively stable and predictable standard of value. For Argentina the challenge of achieving a foreseeable and stable unit of value was much harder than for other societies. Argentina has historically followed the inflationary path; an issue that remains unsettled even today.
The reason lying behind inflation, i.e. depreciation, has changed in our country. Before a national currency became legal public tender, there were several provincial currencies in circulation, Buenos Aires currency coming to the fore. In times of civil war and fights between provinces, before the issuance of the first national currency, military expenditure exceeded tax revenue. In 1881, after Buenos Aires was defeated by Avellaneda and Roca, its currency—which had already depreciated by 96%—was replaced by the national currency.
In 1883, the first peso “national currency” completed the replacement of provincial currencies. Such paper currency circulated at par value with the gold peso, a metal currency, as recommended by the manuals of the gold standard of that time. Such quality standard of maintaining a fixed parity between paper and gold did not last long: the first devaluation took place as early as January 1885. The gold standard lasted a year and a half. The expansionary policy, followed by Roca and his successor Juárez Celman, which also required financing to other provinces with scarce resources, led to what was then known as ´wallpapering´ (monetary financing to the national tax authority) and, ultimately, to the 1890 outbreak. Against a background of monetary instability, Juan Balestra wrote a book on that crisis. In his words, “When in a time, surely distant, a standard of value be achieved, who doubts that we will look backwards with the same surprise we express today at the times when a foot or hand was a standard to measure space, a watch sand measured time, and fever was felt by a doctor´s hand!´. And shortly after, in the aftermath of the crisis, a British, Lawson quoted: ´Argentine people change their currency as often as they have president rotation (…) No people in the world have an interest so deep in monetary experiments.”
After several decades of greater stability, during the second half of the 20th century, Argentine people lost their trust in the Argentine peso as a reliable unit of value. No country in the world has so many years of inflation over 20% as Argentina in the last seven decades. As in the 19th century, part of the difficulty in providing the society with a stable and predictable unit of value was that currency issuance was used as source of tax revenue. At times inflation was a collateral effect of both the BCRA’s financing channeled to the government and a specific and intentional decision of the monetary authority: to undervalue currency, to depreciate it. This was a strategy to undervalue wages in terms of international currency, a competitiveness shortcut that did not last in time and led to the present inflation. At some other times, anxiety led us to find a stable unit of value following a different shortcut: peg our currency to a foreign currency in order to, so to speak, enjoy their stability. Nonetheless, to fix our currency to another country’s currency seeking a foreseeable and moderate inflation implied a rise in the value of our goods and services in line with the standard currency. So, in a changing world this shortcut comes to an end. This way of fixing the price of currency ended up in an inflation outburst (generally sooner than later) after the government or the market were persuaded that argentine prices in international currency were not sustainable at such exchange rate.
In other words, Argentine currency was never a foreseeable and stable unit of value because the monetary policy always had other targets: financing deficit, keeping currency undervalued or—as an anti-inflationary shortcut that confused means with ends—fixing the value of Argentine currency in terms of foreign currencies.
During 2016, the BCRA moved to inflation targeting based on the obvious premise that if we want to control inflation, the BCRA´s target must be to control inflation. As a kind of game, I´ve prepared seven questions and answers on inflation targeting:
1. Is inflation target contradictory to other targets of the BCRA? In accordance with the Charter of the BCRA, the purpose of the BCRA is to promote monetary stability, financial stability, employment, and economic development with social equality. It is quite obvious that foreseeable and moderated inflation favors financial stability, a necessary condition for a sustainable economic development, and that limiting the inflationary tax, inherently the most regressive, favors social equity. However, there is a conflict between price stability and high levels of employment, isn’t there?
The well-known ´Phillips Curve´, which is in fact an empirical observation formulated by the American economist Irving Fisher in 1926, postulates an inverse relationship between the rate of inflation and the level of employment, i.e. more inflation, less unemployment and vice versa.
However, nearly half a century later we are aware that the Phillips-Fisher Curve has a flaw. There is considerable consensus among economists as to the negative effect in employment if the monetary authority sets an unexpected disinflation process in motion. For example: if in a particular year contracts were signed with an inflation expectation of 30% but the monetary authority seeks a 10% inflation, the mismatch between expected and actual inflation may entail recession as costs increase more than prices. Therefore, unexpected disinflation may be recessive for a while and, conversely, unexpected inflation may be expansive for a short period. However, the relationship between inflation and unemployment is not that simple. In fact, just to give an example, during the last 15 years the three years with highest inflation were also years of recession (2002, 2014 and 2016).
Inflation targeting actually seeks the opposite to inflationary or deflationary surprise. It seeks predictability by announcing an inflation target or range, and by using instruments of monetary policy for its achievement. To the extent that such target or range is trustworthy and economic players come up to such expectations, there is nothing better for economic activity and employment than to validate those expectations with monetary policy.
For the same reason, inflation targeting does not imply that the countercyclical role of the monetary policy should be abandoned. Where a country with, let’s say, 5% inflation target enters into recession, the expected impact of the lower level of activity should be a slowdown in inflation below 5%. In order to prevent inflation from dropping below the level sought, monetary policy has to be expansive in that context; this is what the economy needs to avoid unemployment. In any case, credibility is a fundamental factor in a viable inflation targeting scheme. This leads us to the second question.
2. Why targets should be achieved gradually? During this year of transition to inflation targeting, the BCRA seeks a 1.5% monthly inflation or lees during the last quarter of the year. As to the last Market Expectations Survey carried out at the end of August, leaving aside the expected effects of tariff changes (disinflationary in August and September, plus the expected inflation in some of the following months), core inflation will lie close to 1.6%, 1.5% and 1.5% in October, November and December. That is to say, BCRA´s inflation target is close to being completely credible 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 following a monetary policy to bridge the credibility gap.
We believe that gradual target is vital to achieve the goal of credibility. Our daily duty is to persuade economic players that the monetary policy will be adjusted along the following months in order to lower inflation below 17%, as we convinced people that monetary policy would be adjusted to achieve a goal of 1.5% as a maximum in the last quarter. This is a possible goal; besides, a more ambitious goal would be much harder. Therefore, we have adopted a gradual path to disinflation that includes a 5% goal as from 2019. This leads us to the third question.
3. Why not fix a final target below 5%? At this stage many central banks of developed countries with 2% inflation targets wonder if this target may hinder their monetary policy just because it’s too low. In fact, many countries get caught in a deflation trap from which they cannot free themselves even with negative interest rates, which hinders their return to the path of economic expansion and to their low but positive inflation target. Currently, many countries in the world discuss if a higher target can grant a greater margin for maneuver. For instance, with a 5% inflation target, a 0% interest rate (almost a floor for monetary policy) is more expansionary than in a scenario of 2% inflation, as it implies a lower real interest rate.
For an emerging country like Argentina, which is frequently exposed to external shocks, a 5% target may be appropriate but for another reason. When the economy needs to become cheaper in international terms (for example as a result of an international crisis), a 5% target allows accommodating such impact with monetary depreciation without increasing inflation or decreasing deflation. On the contrary, if inflation targets were 0%, an adjustment of relative prices towards a greater real exchange rate may entail nominal deflation of certain prices so as not to deviate from the target. We know that even though we do not believe in the Phillips Curve, price deflation may call for recession.
Once again it is worth noting that gradual and reasonable inflation targeting is not on the opposite side of full employment, quite the contrary.
4. Would the peso serve as a unit of value if disinflation lasted for more than three years and yet inflation only came down to 5%? With one-digit inflation, prices begin to make sense. During high inflation periods, nobody knows the price of things (with this in mind, marketing experts cause supermarkets to compete by advertising discounts rather than prices). Regarding the comparison between current and future prices, contracts may reflect inflation expectations more accurately to the extent that the BCRA gradually fulfills its targets and economic players align their inflation expectations to the announced targets. Financial contracts shall have decreasing nominal interest rates.
Therefore, the BCRA holds that in order to deal with the disinflation process, particularly in the long-term, it makes sense to allow economic players to protect their contracts against inflation, even with 5% inflation. Consequently, following the successful method of Chile, Colombia or Uruguay, the BCRA promoted a unit of account protected against inflation that is based on the consumer price index. One of the advantages of the unit of account protected against inflation is that it allows matching loan installments to the nominal payment capacity over time. Even with 5% inflation rate, the real value of a fixed nominal payment to be made over the following 25 years would fall 70% compared to the same nominal payment made today. Hence, in a fixed installment loan the initial installments should bear the value lost in the final installments. This entails a huge barrier for low income families to access long term credit because they cannot afford high initial installments. The unit of account has a real constant value, which enables to establish a sound relationship between each payment and the current level of prices at a given time.
5. Does inflation targeting imply higher interest rates? No. In the long term anything that implies greater predictability entails less risk and, therefore, less extra rate for that risk. Interest nominal rates, in regular conditions, must reflect the expected inflation, and usually when disinflation is sought, a real positive rate and an extra real rate. It should be noted that monetary policy rate currently set by the BCRA (35-day LEBAC) is a short term rate. In order to determine the bias of monetary policy, nominal interest rate must be compared to the corresponding period. For example: while the BCRA kept a 38% interest rate between March and May, the effective monthly inflation rate was 3.16%. It was adequate to compare 3.16% to the expected inflation for those months, instead of 38% against the expected inflation for the whole year.
The last two questions are concerned with the amount of money and exchange rate; two issues that may awaken passions.
6. How does the amount of money play within inflation targeting? In a scheme where the monetary authority sets the interest rate, the amount of money (whether ´monetary base´ or other aggregates) is a consequence, a result, a bow from which no causal arrow is shot. In the jargon of central bankers: “we have not abandoned monetary aggregates, they have abandoned us”.
How does this system exactly work? Let’s analyze the case of Argentina today. Each Tuesday the BCRA sets the interest rate for the sale of its securities with 35 days maturity. At the same time (and more importantly) it shall operate at that rate over the rest of the week in the securities market. Let´s think about the market from banks or other financial agents’ point of view. For the sake of simplicity, we can imagine that they have to choose between 3 low risk assets: liquidity in pesos with no interest payment, LEBAC with interest payment or foreign currency. If for whatever reason the demand for liquidity increases, securities may promptly be sold at a pre-determined rate to the BCRA. In contrast, if there is surplus liquidity, they may buy as many securities as they may need to get rid of any surplus liquidity and, in turn, the BCRA will be prepared to sell those securities (i.e. absorb liquidity) at the monetary policy rate. In other words, the demand for pesos determines the monetary offer and not vice versa. Indeed, by controlling the interest rate the BCRA may influence on the amount of money demanded (the lowest the rate, the less expensive is to keep liquidity); however the BCRA spots the light on the rate.
In order to consider the monetary policy effect on inflation is not necessary to analyze monetary aggregates. The interest rate affects the course of inflation by channels that are independent from the amount of money. In the first place, by altering expenditure and saving incentives. Secondly, because the monetary policy affects, though unintentionally, the domestic currency price compared to other currencies.
Thirdly, and more importantly, its value is a sign of commitment. Where the public is aware that the monetary authority uses the interest rate to achieve inflation targets, they bear in mind such targets to build up their inflation expectations and, in turn, expectations have a bearing on inflation as they are taken as a basis for contracts (financial, rent, employment, just to mention a few).
Frankly, we believe that the BCRA had a successful year in persuading those that closely follow its actions that the monetary policy reacts in order to achieve its inflation targets. Every new inflation datum is read by market experts as a sign of how the BCRA will act. The belief that the BCRA is being responsive to inflation is a necessary condition for inflation targeting. In addition, the belief that the Bank´s policy is the most appropriate to fulfill its goal—something we are close to attain—is already a sufficient premise. All in all, inflation targeting may be defined as a regime that makes the society rely on the monetary policy implemented that will lead to obtain the inflation rate set in the targets.
7. And what about the dollar? My closest friends know they cannot do it but anyway they ask me: should I buy dollars or stand on the interest rate side? Even though I knew the answer, I would answer: “of course, I do not know”; however I am pleased to know I actually do not know the answer. Maybe the greatest virtue of inflation targeting with floating exchange rate is that nominal currency depreciations or appreciations are never anticipated, thus no speculation towards one side or the other can be made. The reason is simple: if everyone knew that currency would depreciate, depreciation would occur at once, and so people would stop thinking about depreciation just because currency depreciation had already taken place. The same would happen with appreciation.
Therefore, neither the nominal exchange rate nor the real exchange rate can be foreseen. Even though economic science questions the empiric validity of the so-called ´uncovered interest rate parity´, the truth is that economists in general believe that there must be a certain relationship between the interest rate in pesos (the amount paid, let’s say, for a LEBAC) and expected devaluation (the amount in pesos paid for staying on dollars). If that was not the case, one of those assets would not be requested.
However, let´s combine the idea of matching interest rate with expected inflation and, for example, a monetary policy that intends to set a slightly positive real interest rate. Slightly positive real rate means that the nominal interest rate is somewhat higher than the expected inflation. But then, in expected value, a slightly positive real interest rate policy implies that the market is waiting for a nominal depreciation barely higher than the inflation rate or, in other words, a small increase in the real exchange rate. Of course, such expectation is in fact something like the expected value in a probability distribution. In this sense, markets believe that the real exchange rate may rise, drop or remain constant.
Have I said anything about foreign exchange policy? I only mean that if people believe in financial market prices, we cannot assert for sure that the exchange rate will move towards one of the sides of the expected depreciation curves. Neither can we assert that the real exchange rate will change one direction or another.
Are there many uncertainties? I do not think so. I believe they are appropriate. In an inflation targeting the monetary authority does not seek to give certainty about such issues it cannot because they are beyond its scope of action. In fact, inflation targeting seeks to be as foreseeable as possible about the subjects that do depend on the monetary authority: the purchase power of that currency whose care was entrusted with.
Our everyday duty is that the BCRA lives up to that responsibility.
Thank you.
