Banxico's Monetary Policy Dilemma

Commentary on the Financial Times forum beyondbrics.

March 1, 2017

Latin America’s economic performance in the past few years has been dismal. In recent months, the central banks of Brazil, Chile, and Colombia have started cutting interest rates, recognizing the need for monetary stimulus.

In contrast, the day after the US Federal Reserve made its first interest rate hike in December 2015, the Mexican central bank (Banxico) raised rates from 3 to 3.25 percent. It has steadily continued tightening since.

When the tightening cycle began, all measures of Mexican inflation—headline, core, and expectations—were at their lowest levels ever.

Output was growing moderately, at 2.6 percent in 2015, declining to 2.3 percent in 2016 after the tightening started.

Yet interest rates continued rising, reaching 5.25 percent in October 2016; since Donald Trump’s election in the United States, they have risen to 6.25 percent.

Why is an inflation-targeting central bank tightening monetary policy just as a severe negative demand shock has hit the economy?

Consumer and business confidence have fallen to historic lows. There is a serious risk of trade restrictions and other upheavals from the United States. The outlook for this year is grim. The latest Banxico survey reports median expected growth of 1.6 percent, 0.6 percentage points less than before the US elections.

Monetary policy in Mexico faces a serious dilemma. On the one hand is a need to support economic activity; on the other, the fear that if monetary policy is not tightened in line with the Fed funds rate in the United States, there could be significant dislocation in financial markets, with rapid capital outflows and disorderly depreciation.

Indeed, at the time of the first hike, one of the main arguments was about capital flows. This is what Carlos Vegh and Guillermo Vuletin, in a 2012 paper for the National Bureau of Economic Research, call Fear of Free Falling (FFF), which forces central banks to run procyclical monetary policy.

But if the FFF is so significant, why, right after the Brexit vote and the fall in the pound, did the Bank of England cut rates? Why did Australia cut rates from 4.75 percent to 1.5 percent from late 2011, with inflation above its target and against a backdrop of a 40 percent currency depreciation? Why did Canada cut rates in 2015 while facing depreciation?

In Latin America, Chile also cut rates in 2013–14 with a significant depreciation and inflation above target. These countries have been able to run countercyclical monetary policy because they do not suffer from the FFF and their target is medium-term inflation.

There is no evidence that not tightening will induce a disorderly adjustment in financial markets. It cannot be ruled out, but market fears are often induced by policymakers’ fears.

Across the region, including Mexico, there were mild increases in sovereign spreads after the US election, but they have been mostly reversed.

It is not only the level of interest rates that matters for monetary policy, but also how the rate changes.

This is a sign that depreciations have been more fundamentally driven than caused by overshooting or some other financial anomaly.

In the case of Mexico, a depreciation is needed just to sustain the existing savings-investment balance without activity bearing the brunt of the adjustment.

Some may argue that monetary conditions, which combine changes in interest and exchange rates, have not been as contractionary as it seems, since the peso has depreciated significantly.

However, to gauge the degree of monetary expansiveness by looking at the monetary conditions index may be misleading when the depreciation takes place because its fundamental values have changed.

Mexico’s last hike took place against the largest monthly increase in inflation in a long time, 1.7 percent, and could be justified, even though this was largely a one-off adjustment because of the liberalization of petrol prices: Monthly core inflation was lower at 0.5 percent.

However, the whole process of tightening calls into question the argument that it has been driven by a desire to anchor inflation expectations. It has been driven mostly by the fear of free falling.

One year ahead inflation expectations in Mexico have indeed been rising. The Banxico survey shows median inflation for the end of 2017 at 5.2 percent against 3.3 percent two years ago. However, expected inflation for 2018 has only risen 0.3 percentage points.

It is not only the level of interest rates that matters for monetary policy, but also how the rate changes.

Signaling a commitment to low inflation when rates are high may be costly for activity. Banxico is facing a serious challenge. Monetary policy has long and variable lags.

To get out of its current straitjacket, it should focus communication and actions on inflation forecasts for the medium term, say two years, and focus also on medium-term expectations.

In most circumstances, monetary policy should be countercyclical, to contribute to macroeconomic stability.

Much progress has been made by independent central banks with a mandate on price stability. Now, it may be necessary to reduce the excessive significance given to exchange rate developments in the conduct of monetary policy, to get rid of fear of free falling and to strengthen credibility.

José De Gregorio is a professor of economics at the Universidad de Chile and a nonresident senior fellow at the Peterson Institute for International Economics. He was governor of the Central Bank of Chile from 2007 to 2011.

A longer version of this op-ed is available for download below.