## 3. Preserving Hard-Won Monetary Policy Gains amid Persistent Fiscal Risks

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### Introduction
- By the early 2000s, countries in Latin America and the Caribbean (LAC) had achieved price stability supported by sweeping reforms that enhanced central bank independence and strengthened monetary policy frameworks.
- The chapter examines:
  - how Latin America enhanced central bank independence and the effects of these reforms;
  - how fiscal policy may affect channels of transmission of monetary policy; and
  - whether fiscal policy, via high debt levels and sustained deficits, affects central bank credibility and the ability to achieve inflation targets.
- Prepared by Agnese Carella, Dimitris Drakopoulos (co-lead), Juan Passadore (co-lead), and Genevieve Lindow.

### Central Bank Reforms
- Reforms in the 1990s substantially bolstered central bank independence (CBI) across the region.
- Key reform areas and outcomes:
  - Monetary financing
    - Restriction of central bank financing to the government was a cornerstone reform.
    - Restrictions were codified and largely respected, resulting in a substantial reduction in central bank claims against the public sector.
    - During the pandemic, amid fiscal pressures, central banks largely refrained from direct monetary financing.
  - Price stability
    - Price stability became the primary objective for most central banks.
    - Around three quarters of central banks prioritize price stability (including “price stability only goal” and “price stability (no conflicts)” categories).
  - Political influence in decision making
    - Governance reforms introduced longer and staggered terms for board members and stricter conditions for removal, reducing alignment with electoral cycles.
    - Government representation on central bank boards declined, though in some cases the minister of finance retained a seat—typically without voting rights; Colombia is an exception where the minister of finance participates as a full voting member.
    - Exceptions: Peru and Uruguay have board terms that align with political cycles; Brazil implemented staggered terms in 2021.
  - Financial independence
    - Reforms have been less pronounced; some countries have automatic government recapitalization rules, others have discretionary arrangements or lack them.
    - Several central banks still show inadequate capitalization and await recapitalization agreements with the government.
    - Negative capital is not inherently problematic—Chile and Mexico have operated with negative equity in some years while fulfilling mandates.
- Impact of reforms
  - Increased CBI was associated with lower long-term inflation levels in LAC compared to other emerging market and developing economies (EMDEs), based on local projections over 1980–2023 controlling for output gap, inflation, exchange rate regime, fiscal factors, and external variables.
  - Quantile analysis shows coefficients on the CBI index decline across inflation quantiles and become notably more negative at higher inflation levels; the relationship is larger in LAC than in EMDEs.
  - Reforms improved inflation anchoring, monetary policy effectiveness, lower sacrifice ratios, and increased resilience.
  - In LA5 (Brazil, Chile, Colombia, Mexico, Peru), credibility strengthened and inflation expectations anchoring improved since the mid-2000s.
  - Time-varying vector autoregression analysis across LA5 indicates strong transmission of monetary policy to inflation, comparable to advanced economies.

### Interactions between Monetary and Fiscal Policy
- Overview
  - Monetary and fiscal policies interact via aggregate demand and through effects of debt levels and fiscal stance on local currency bond spreads, inflation expectations, and the exchange rate risk premium.
  - High debt amplifies aggregate demand through wealth effects and raises the risk central banks will accommodate fiscal needs.
- Debt levels and monetary policy
  - Monetary policy decisions affect fiscal accounts through financing costs, especially when debt is high and maturity is short.
  - The region’s current debt levels and interest payments are high compared to other regions and historical standards.
  - Despite improvements in debt composition (less foreign currency debt and longer average maturity), amounts of floating and indexed rate debt remain substantial in some countries—leading to more immediate pass-through from monetary policy to debt-servicing costs compared to advanced economies.
  - Empirical evidence:
    - In EMs with low debt levels, monetary policy tightening is effective in reducing inflation: it leads to exchange rate appreciation, lower short-term inflation expectations, and convergence of inflation to target; it also lowers long-term yields, indicating reduced risk premium and alleviating fiscal impacts.
    - In high-debt environments—defined as having current debt levels higher than the 80th percentile in the past 20 years—monetary policy shocks have no significant impact on exchange rates, short-term inflation expectations, or long-term yields.
    - Estimates of Taylor rules in EMs show the policy rate responds more to inflation in low-debt economies compared to high-debt economies, suggesting elevated debt may limit willingness or ability of central banks to tighten policy.
- Monetary and fiscal policy mix
  - The fiscal stance influences monetary policy effectiveness in achieving inflation targets.
  - At the onset of the pandemic, both monetary and fiscal policies were expansionary.
  - Monetary policy tightened significantly in 2021 and 2022—contributing to a rapid decline in inflation after COVID-19 shocks—but needed fiscal consolidations have been delayed.
  - Fiscal policy has stayed expansionary in recent years in several countries, creating a policy mix that may have slowed the disinflation process.
  - Local projections for selected EMDEs suggest a surprise increase in structural primary deficits—defined as the difference between actual and the October World Economic Outlook (WEO) projection of the year—pushes aggregate demand and complicates disinflation when monetary policy is restrictive.

### Empirical Analyses and Measurement
- Monetary policy shocks and debt interaction
  - Response analyzed to a 100-Basis-Point monetary policy tightening shock at an 18-Month horizon.
  - Interaction indicator: debt higher than the 80th percentile.
  - Findings reported as bI (direct response) and bI + gI (additional response when debt > 80th percentile).
  - Variables and measurement:
    - Inflation, inflation expectations, and LT yields denote change in level of the variable (measured in percent).
    - Exchange rates are measured in logs; an increase denotes depreciation.
    - Monthly frequency.
  - Country sample: Brazil, Chile, Colombia, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Nigeria, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Türkiye.
- Estimated policy reaction (Taylor rule) and debt
  - Taylor rule specification:
    - ii,t = a i i,t−1 + b1 p i,t + b2 p i,t Interaction it + g i x i,t + є i,t
    - Interaction is an indicator for each country that debt is higher than the 80th percentile.
  - Bars depict b1/(1−a) and (b1 + b2)/(1−a).
  - Quarterly frequency.
  - Comparison periods referenced: 2022 and 2024.
- Impact of fiscal deficit shocks on inflation
  - Local projections specification for fiscal deficit shocks:
    - Υc,t+h − Υc,t = ac + dt + bI FPt + Σk=0 gh Controlsc,t−k + uit
    - FPt is the fiscal deficit shock; fiscal deficit shocks computed from World Economic Outlook forecast errors on structural primary balance.
    - Controls include current and lagged real GDP growth and debt to GDP.
    - Annual frequency.
  - Main empirical finding:
    - Fiscal deficits raise inflation and inflation expectations at both one- and two-year horizons.
    - Figures report magnitudes up to 3.0 (percent) on the vertical axis for inflation and 1-year inflation expectations.
  - Sample for fiscal deficit shock analysis: Brazil, Chile, Colombia, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Nigeria, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Türkiye.

### Policy Implications and Recommendations
- Preserve public debt levels that do not undermine monetary policy transmission through effects on expectations and asset prices.
- Maintain the ability of central banks to implement appropriate interest rate policy.
- Credible fiscal consolidation is critical to:
  - Stabilize debt.
  - Create fiscal space.
  - Keep monetary policy effective.
- Strengthen fiscal rules and policy frameworks; consider well-calibrated debt anchors where appropriate.
- Further strengthen central bank independence (CBI):
  - Enhance governance of central bank boards.
  - Bolster financial independence through budgetary autonomy and proper capitalization.
  - Continue reforms that reduce monetary financing of the budget and improve central bank mandates and governance.

### Notes on aggregates and samples
- Aggregates are simple averages.
- AE = Germany, Japan, United Kingdom, the United States; AE sample excludes Japan in one footnote.
- EM = emerging markets; EM sample includes Hungary, Indonesia, Malaysia, Philippines, Saudi Arabia, South Africa, Thailand, and Türkiye.
- EM Asia = India, Indonesia, Malaysia, Philippines, Thailand, Vietnam.
- EM Europe = Bosnia and Herzegovina, Bulgaria, Hungary, Poland, Romania, Serbia.
- FC = foreign currency.
- LAC = Latin America and the Caribbean.
- LA5 = Latin America 5 (Brazil, Chile, Colombia, Mexico, Peru).
- LA7 = Latin America 7 (Brazil, Chile, Colombia, Mexico, Paraguay, Peru, Uruguay).

*Source: IMF staff calculations and figures from chapter “Preserving Hard-Won Monetary Policy Gains amid Persistent Fiscal Risks,” October 2025, INTERNATIONAL MONETARY FUND.*

### 3. Preserving Hard-Won Monetary Policy

### 3. Preserving Hard-Won Monetary Policy Gains amid Persistent Fiscal Risks

### Introduction
- By the early 2000s, countries in Latin America and the Caribbean (LAC) had achieved price stability supported by sweeping reforms that enhanced central bank independence and strengthened monetary policy frameworks.
- These reforms anchored inflation expectations and enabled effective monetary transmission, but fiscal frameworks and policies continue to raise challenges—particularly associated with high debt levels and interest costs—which can amplify the fiscal impact of monetary policy and hinder monetary policy transmission.
- This chapter explores:
  - how Latin America enhanced central bank independence and the effects of these reforms;
  - how fiscal policy may affect channels of transmission of monetary policy; and
  - whether fiscal policy, via high debt levels and sustained deficits, affects central bank credibility and the ability to achieve inflation targets.

### Central Bank Reforms
- Reforms in the 1990s substantially bolstered central bank independence (CBI) across the region.
- Key reform areas and outcomes:
  - Monetary financing
    - A cornerstone reform was the restriction of central bank financing to the government.
    - Restrictions were codified and largely respected in practice, resulting in a substantial reduction in central bank claims against the public sector.
    - During the pandemic, amid fiscal pressures, central banks largely refrained from direct monetary financing.
  - Price stability
    - Price stability became the primary objective for most central banks.
    - Around three quarters of central banks prioritize price stability (including “price stability only goal” and “price stability (no conflicts)” categories).
  - Political influence in decision making
    - Governance reforms introduced longer and staggered terms for board members and stricter conditions for removal, reducing alignment with electoral cycles.
    - Progress reduced government representation on central bank boards, though in some cases the minister of finance retained a seat—typically without voting rights; Colombia is an exception where the minister of finance participates as a full voting member.
    - Exceptions: Peru and Uruguay have board terms that align with political cycles; Brazil implemented staggered terms in 2021.
  - Financial independence
    - Reforms have been less pronounced; some countries have automatic government recapitalization rules, others have discretionary arrangements or lack them.
    - Several central banks still show inadequate capitalization and await recapitalization agreements with the government.
    - Negative capital is not inherently problematic—Chile and Mexico have operated with negative equity in some years while fulfilling mandates.
- Impact of reforms
  - Increased CBI was associated with lower long-term inflation levels in LAC compared to other emerging market and developing economies (EMDEs), based on local projections over 1980–2023 controlling for output gap, inflation, exchange rate regime, fiscal factors, and external variables.
  - Quantile analysis shows coefficients on the CBI index decline across inflation quantiles and become notably more negative at higher inflation levels; the relationship is larger in LAC than in EMDEs.
  - Reforms improved inflation anchoring, monetary policy effectiveness, lower sacrifice ratios, and increased resilience.
  - In LA5 (Brazil, Chile, Colombia, Mexico, Peru), credibility strengthened and inflation expectations anchoring improved since the mid-2000s.
  - Time-varying vector autoregression analysis across LA5 indicates strong transmission of monetary policy to inflation, comparable to advanced economies.

### Interactions between Monetary and Fiscal Policy
- Overview
  - Monetary and fiscal policies interact via aggregate demand and through effects of debt levels and fiscal stance on local currency bond spreads, inflation expectations, and the exchange rate risk premium.
  - High debt amplifies aggregate demand through wealth effects and raises the risk central banks will accommodate fiscal needs.
- Debt levels and monetary policy
  - Monetary policy decisions affect fiscal accounts through financing costs, especially when debt is high and maturity is short.
  - The region’s current debt levels and interest payments are high compared to other regions and historical standards.
  - Despite improvements in debt composition (less foreign currency debt and longer average maturity), amounts of floating and indexed rate debt remain substantial in some countries—leading to more immediate pass-through from monetary policy to debt-servicing costs compared to advanced economies.
  - Empirical evidence:
    - In EMs with low debt levels, monetary policy tightening is effective in reducing inflation: it leads to exchange rate appreciation, lower short-term inflation expectations, and convergence of inflation to target; it also lowers long-term yields, indicating reduced risk premium and alleviating fiscal impacts.
    - In high-debt environments—defined as having current debt levels higher than the 80th percentile in the past 20 years—monetary policy shocks have no significant impact on exchange rates, short-term inflation expectations, or long-term yields.
    - Estimates of Taylor rules in EMs show the policy rate responds more to inflation in low-debt economies compared to high-debt economies, suggesting elevated debt may limit willingness or ability of central banks to tighten policy.
- Monetary and fiscal policy mix
  - The fiscal stance influences monetary policy effectiveness in achieving inflation targets.
  - At the onset of the pandemic, both monetary and fiscal policies were expansionary.
  - Monetary policy tightened significantly in 2021 and 2022—contributing to a rapid decline in inflation after COVID-19 shocks—but needed fiscal consolidations have been delayed.
  - Fiscal policy has stayed expansionary in recent years in several countries, creating a policy mix that may have slowed the disinflation process.
  - Local projections for selected EMDEs suggest a surprise increase in structural primary deficits—defined as the difference between actual and the October World Economic Outlook (WEO) projection of the year—pushes aggregate demand and complicates disinflation when monetary policy is restrictive.

*Prepared by Agnese Carella, Dimitris Drakopoulos (co-lead), Juan Passadore (co-lead), and Genevieve Lindow.*

### 1. Gross Public Debt

### 1. Gross Public Debt

### Monetary policy shocks and debt interaction
- Response analyzed to a 100-Basis-Point monetary policy tightening shock at an 18-Month horizon.
- Interaction indicator: debt higher than the 80th percentile.
- Findings from local projections (Checo, Grigoli, and Sandri (2024) specification):
  - Left panel in Figure 3.8 reports bI (direct response).
  - Right panel in Figure 3.8 reports bI + gI (additional response when debt > 80th percentile).
- Variables and measurement:
  - Inflation, inflation expectations, and LT yields denote change in level of the variable (measured in percent).
  - Exchange rates are measured in logs; an increase denotes depreciation.
  - Monthly frequency.
- Country sample for Figures 3.8 and 3.9 and other local projections:
  - Brazil, Chile, Colombia, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Nigeria, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Türkiye.

### Estimated policy reaction (Taylor rule) and debt
- Taylor rule estimation specification:
  - ii,t = a i i,t−1 + b1 p i,t + b2 p i,t Interaction it + g i x i,t + є i,t
  - Interaction is an indicator for each country that debt is higher than the 80th percentile.
  - Bars in Figure 3.9 depict b1/(1−a) and (b1 + b2)/(1−a) respectively.
- Quarterly frequency.
- Comparison periods referenced in visual: 2022 and 2024.

### Impact of fiscal deficit shocks on inflation
- Local projections specification for fiscal deficit shocks:
  - Υc,t+h − Υc,t = ac + dt + bI FPt + Σk=0 gh Controlsc,t−k + uit
  - FPt is the fiscal deficit shock; fiscal deficit shocks computed from World Economic Outlook forecast errors on structural primary balance.
  - Controls include current and lagged real GDP growth and debt to GDP.
  - Annual frequency.
- Main empirical finding:
  - Fiscal deficits raise inflation and inflation expectations at both one- and two-year horizons (Figure 3.11).
  - Figure 3.11 reports separate series for inflation and 1-year inflation expectations with magnitudes displayed on the figure up to 3.0 (percent) on the vertical axis.
- Sample for fiscal deficit shock analysis:
  - Brazil, Chile, Colombia, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Nigeria, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Türkiye.

### Policy implications and recommendations
- Preserve public debt levels that do not undermine monetary policy transmission through effects on expectations and asset prices.
- Maintain the ability of central banks to implement appropriate interest rate policy.
- Credible fiscal consolidation is critical to:
  - Stabilize debt.
  - Create fiscal space.
  - Keep monetary policy effective.
- Strengthen fiscal rules and policy frameworks; consider well-calibrated debt anchors where appropriate (see IMF 2024a referenced in source).
- Further strengthen central bank independence (CBI):
  - Enhance governance of central bank boards.
  - Bolster financial independence through budgetary autonomy and proper capitalization.
  - Continue reforms that reduce monetary financing of the budget and improve central bank mandates and governance.

### Notes on aggregates and samples
- Aggregates are simple averages.
- Advanced economies (AE) = Germany, Japan, United Kingdom, the United States; AE sample excludes Japan in one footnote.
- EM = emerging markets; EM sample includes Hungary, Indonesia, Malaysia, Philippines, Saudi Arabia, South Africa, Thailand, and Türkiye.
- EM Asia = India, Indonesia, Malaysia, Philippines, Thailand, Vietnam.
- EM Europe = Bosnia and Herzegovina, Bulgaria, Hungary, Poland, Romania, Serbia.
- FC = foreign currency.
- LAC = Latin America and the Caribbean.
- LA5 = Latin America 5 (Brazil, Chile, Colombia, Mexico, Peru).
- LA7 = Latin America 7 (Brazil, Chile, Colombia, Mexico, Paraguay, Peru, Uruguay).

*Source: IMF staff calculations and figures from chapter “Preserving Hard-Won Monetary Policy Gains amid Persistent Fiscal Risks,” October 2025, INTERNATIONAL MONETARY FUND.*

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_Source: https://www.imf.org/-/media/files/publications/reo/whd/2025/october/english/ch3.pdf_