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### I. Introduction
- The 2008 global financial crisis reshaped central banking in Latin America.
- Three central challenges identified:
  - Delivering price stability where inflation remains high and volatile; fiscal policy often the root cause; strengthening central bank independence is an important disinflationary strategy.
  - For inflation-targeting countries, unusually high uncertainty about potential output, the natural interest rate, and the equilibrium real exchange rate complicates policymaking; improvements in communication, anchoring expectations, and clarifying exchange rate and reserve roles are needed.
  - Powerful external financial cycles can influence or overpower domestic monetary policy and destabilize financial systems, prompting reconsideration of central bank roles in financial stability and coordination between monetary and macroprudential policies.
- Paper organization summary:
  - Section II: progress and reversals in monetary policy.
  - Section III: refinements to improve inflation-targeting regimes.
  - Section IV: the role of the exchange rate and communication improvements.
  - Section V: implications of central banks’ role in financial stability.
  - Section VI: conclusions.

### II. Defeating Inflation — Achievements and Reversals

- Central bank reform and institutional change
  - Four pillars of new central banking legislation:
    - (i) definition of a clear and narrow mandate;
    - (ii) formulation of central bank policies independent of the executive branch;
    - (iii) autonomy of monetary policy implementation;
    - (iv) accountability of central banks.
  - Selected timeline of constitutional/legislative reforms:
    - Chile: 1989.
    - El Salvador: 1991.
    - Argentina, Colombia, Ecuador, Nicaragua, Venezuela: 1992.
    - Mexico, Peru: 1993.
    - Bolivia, Costa Rica, Paraguay, Uruguay: 1995.
    - Honduras: 1996.
    - Dominican Republic, Guatemala: 2002.
    - Brazil: has not amended its central bank law since 1964 (exception noted).
  - Variations in mandates and functions:
    - Price stability became the single or primary objective in most central banks.
    - Some central banks combine price stability with payments system operation (Chile, Honduras, Nicaragua) or banking regulation/supervision (Argentina, Brazil, Paraguay, Uruguay, Costa Rica, Mexico).
    - Brazil: use of monetary policy to promote economic development is not legally restricted.
    - Argentina reintroduced the development objective in 2012.
    - Venezuela since 2001 required to coordinate monetary policy with the government to “achieve the highest objectives of the State and the Nation.”
  - Restrictions on government financing:
    - Financing the government deficit was strictly restricted or banned constitutionally in Chile, Colombia, Ecuador, Guatemala, Mexico, and Peru.
  - Accountability mechanisms:
    - Central banks required to submit reports to the executive and legislative branches, publicly disclose decisions, governors may be required to appear before Congress.

- Measuring central bank independence
  - Legal independence increased significantly after reforms; many central banks more than doubled their independence scores following reform.
  - Modified index characteristics:
    - Broader view of political independence (all board members).
    - Incorporates central banks’ financial independence, accountability, and transparency.
  - Empirical associations:
    - Greater central bank independence associated with lower inflation (Jácome and Vázquez (2008)).
    - Panel regressions for 1985–2002 found a statistically significant positive correlation between structural reforms and legal central bank independence, controlling for international inflation, banking crises, and exchange rate regimes.
    - Causality from legal independence to inflation not established; causality found when using turnover rate of central bank governors as de facto independence measure.
  - Selected country index changes (from Table 2):
    - Argentina* 1992: Pre-reform 0.31, Post-reform 0.83.
    - Bolivia* 1995: Pre-reform 0.33, Post-reform 0.83.
    - Chile 1989: Pre-reform 0.26, Post-reform 0.85.
    - Colombia 1992: Pre-reform 0.29, Post-reform 0.83.
    - Mexico 1993: Pre-reform 0.39, Post-reform 0.81.
    - Peru 1993: Pre-reform 0.50, Post-reform 0.84.
    - Venezuela* 1992: Pre-reform 0.40, Post-reform 0.69.
    - Note: * denotes countries where subsequent legislation has reverted these reforms to some extent.  denotes countries where subsequent legislation furthered central bank independence.
  - Brazil did not approve legislation to grant independence to the central bank.

- A new policy framework and exchange rate regimes
  - By 2015:
    - Ten of the 18 countries in the region had adopted a flexible regime, up from six in 1990.
    - Five countries still kept a soft peg.
    - Three countries used the U.S. dollar as legal tender.
  - “Fear of floating” and interventions:
    - Early skepticism led countries to repeatedly intervene in FX markets to restrict flexibility and build reserves.
  - Strengthening international reserves:
    - Bolivia and Peru increased gross reserves minus gold to more than 30 percent of GDP by 2015 from less than five percent.
    - By 2015, Brazil and Mexico had boosted international reserves to 20 and 15 percent of GDP, respectively.
    - Reserve accumulation in most countries benefited from favorable external conditions associated with the supercycle in global commodity prices.

### III. Inflation Targeting, Decision Making, Communication, and Transparency (LA5)

- LA5 countries: Brazil, Chile, Colombia, Mexico, Peru.
- Inflation-targeting operational choices and communication (as reported):
  - Brazil:
    - Target: 4.5% (+/-2).
    - Policy meetings: 8 per year.
    - Issue press release: Yes.
    - Issue minutes: Yes.
    - Publication of votes: Balance of votes.
    - Inflation report: 4 per year.
  - Chile:
    - Target: 3% (+/-1).
    - Policy meetings: Monthly.
    - Issue press release: Yes.
    - Issue minutes: Yes.
    - Publication of votes: Balance of votes.
    - Inflation report: 4 per year.
  - Colombia:
    - Target: 3% (+/-1).
    - Policy meetings: Monthly.
    - Issue press release: Yes.
    - Issue minutes: Yes.
    - Publication of votes: Majority/consensus.
    - Inflation report: 4 per year.
  - Mexico:
    - Target: 3% (+/-1).
    - Policy meetings: 11 per year.
    - Issue press release: Yes.
    - Issue minutes: Yes.
    - Publication of votes: No.
    - Inflation report: 4 per year.
  - Peru:
    - Target: 2% (+/-1).
    - Policy meetings: Monthly.
    - Issue press release: Yes.
    - Issue minutes: No.
    - Publication of votes: No.
    - Inflation report: 4 per year.
- Common features:
  - All LA5 central banks chose a point target with a tolerance band using the consumer price index.
  - All issue a quarterly inflation report and hold pre-announced monetary policy meetings.
  - Brazil and Chile provide information on how votes were cast; Peru does not issue minutes.

### IV. Achieving Low and Stable Inflation — Outcomes and Reversals

- Regional outcomes:
  - Institutional and policy reforms led inflation to plunge by the mid-1990s; many countries achieved low and stable inflation during the mid-2000s.
- Persistent exceptions and recent high-inflation cases:
  - Venezuela: inflation surged to triple digits.
  - Argentina: estimated to have averaged more than 30 percent since 2014.
  - As of mid-2016, Venezuela and Argentina displayed the highest rates of inflation in the world per the text.
  - Brazil and Uruguay: inflation recently hovered around ten percent.
- Causes of high inflation in affected countries:
  - Deterioration in public finances and fiscal dominance.
  - Governments pressuring central banks to finance fiscal deficits.
  - Institutional weaknesses in central banks, lax fiscal policies, wage indexation.
- Policy implication:
  - Consolidate central bank independence and strengthen fiscal frameworks in high-inflation countries to lay basis for price stability.

### V. Output Gap Measurement, Neutral Rate, and Expectations

- Output gap estimation challenges:
  - Potential output is unobservable; real-time estimates subject to substantial revisions and judgment.
  - Real-time estimates tend to overestimate slack (bias toward overestimating slack), often revised to overheating later.
  - Median revision to output gap during the first year: 0.9 percentage points.
  - Additional revisions after two years: almost 0.5 percentage points.
  - Bias larger during recessionary periods; revisions smaller among advanced economies and among inflation-targeting countries.
- Commodity supercycle and medium-term growth vintages (WEO series shown):
  - 4.5, 3.4, 4.2, 2.8, 2.5, 3.0, 3.5, 4.0, 4.5, 5.0.
- Neutral real interest rate considerations:
  - Highly accommodative global financial conditions since 2009 and global savings glut systematically and substantially lowered the neutral real interest rate in Latin America.
  - Neutral rate is an increasing function of potential output growth and the international neutral rate.
  - Slowing potential growth and a declining advanced-economy neutral rate may reduce neutral interest rates in Latin America.
  - A steady policy rate may correspond to a gradually tightening monetary stance if neutral rates are falling.
- Anchoring expectations and communication:
  - Credibility improvements have helped anchor inflation expectations.
  - Examples of deviations of inflation expectations from targets:
    - Brazil: expectations exceeded the central bank’s target for the past six years, reaching deviations of up to 250 basis points at a one-year horizon during 2015.
    - Peru: expectations above target since early 2010, settling around 75 basis points above the midpoint of the range.
    - Mexico: market participants have not expected inflation to reach the central bank’s target in a two-year horizon since early 2006.
  - Disagreement among professional forecasters of 12-month-ahead inflation has declined since early 2000s and aligns with advanced economies such as Australia and Canada.
  - Policy recommendation: improve central bank communication and clarify primacy of price stability to facilitate convergence of expectations.

### VI. Exchange Rate Role, Depreciations, and Monetary Policy Trade-offs

- Recent external shocks and depreciations:
  - Large exchange rate depreciations triggered by shifts in global commodity prices and financial conditions:
    - Start dates: June 2014 for oil producers Brazil, Colombia, Mexico; March 2013 for metals producers Chile and Peru.
  - Recent depreciations were among the largest since the shift to more flexible regimes (except Peru) and have been prolonged (over two years) compared to the 2008 Lehman episode.
- Monetary policy trade-offs for inflation-targeters:
  - Option (i): Keep policy supportive of weak aggregate demand, tolerate inflation above target for some time — requires credible anchoring of inflation expectations.
  - Option (ii): Implement procyclical monetary tightening to offset currency-driven inflation — risks worsening economic slack.
  - Time-horizon flexibility may be required; example: Bank of England’s “within a reasonable time period,” normally interpreted as two to three years.
- Two mitigating factors limiting inflation pressure from depreciations:
  - Decline in exchange rate pass-through coefficients across Latin America, particularly among inflation targeters; in Chile, Colombia, Mexico, and Peru pass-through has fallen to levels in line with advanced economies.
  - Many trade partners also experienced depreciations in a strong U.S. dollar environment, so multilateral exchange rate movements were smaller than bilateral USD depreciations.

### VII. Foreign Exchange Intervention: Motives, Frameworks, Instruments, and Evidence

- Typical objectives for intervention:
  - (i) Price stability (contain depreciation to avoid pass-through inflation).
  - (ii) Financial stability (limit excessive volatility and address currency mismatches).
  - (iii) Buffer building (accumulate international reserves for precautionary purposes).
- Theoretical channels through which intervention may affect exchange rates:
  - Signaling.
  - Portfolio balance channel.
  - Market microstructure channel.
  - Precautionary saving channel.
- Regional practices and trends:
  - Inflation-targeting central banks use intervention subordinated to interest rate policy to react to large movements and excessive volatility.
  - LA5 central banks accumulated substantial international reserves during 2010–2015; Brazil accumulated up to about 7 percentage points of GDP in that period.
  - Reserve accumulation should be sterilized to avoid higher inflation that could de-anchor expectations.
- Intervention frameworks:
  - Rules-based frameworks: Colombia and Mexico previously used rules conditioned on large daily changes; Brazil briefly used a pre-announced program during the “taper tantrum.”
  - Discretionary intervention: Brazil outside pre-announced program, Peru, and more recently Colombia and Mexico.
  - Brazil’s pre-announced program (August 2013 onward): daily auctions of foreign exchange swaps and repos equivalent to US$ 3 billion per week; at peak foreign exchange outstanding balance was about US$ 110 billion.
- Instruments and typical uses:
  - Spot interventions: used mostly by Chile, Colombia, Mexico for financial-stability objectives and liquidity shortages.
  - Swaps / non-deliverable forwards: used by Brazil and Peru; swaps useful for hedging demand and mitigating changes in international reserves.
- Frequency and predictability:
  - Rules-based interventions are partially predictable; discretion-based interventions are less predictable and can amplify instability.
  - Greater transparency and clearer communication can reduce the need to intervene and mitigate market microstructure effects.
- Empirical evidence on effectiveness (selected findings):
  - Mixed evidence overall on intervention reducing volatility and affecting exchange rate levels.
  - Cross-country findings (Appendix):
    - Adler and Tovar (2014): 0.1 of GDP FXI slows down the pace of domestic currency appreciation by 0.3 percent.
    - Adler, Blanchard, and Carvalho (2015): 0.25 percent of GDP FXI reduces appreciation on impact by 1.5 percent.
    - Adler, Lisack, and Mano (2015): 1 percentage point of GDP FXI depreciates the nominal and real exchange rates by [1.7–2.0] percent and [1.4–1.7] percent, respectively.
    - Daude, Levy-Yeyati, and Nagengast (2014): 1 percent increase in FXI weakens the domestic currency by 0.18 percent.
  - Country evidence highlights:
    - Brazil:
      - Barroso (2014): US$ 1 billion buy intervention => 0.45–1.18 percent depreciation; US$ 1 billion selling intervention => 0.46–0.66 percent appreciation; average: 0.5 percent change in domestic currency valuation.
      - Chamon, Garcia, and Sousa (2015): Appreciation in excess of 10 percent following the 2013 Swap Program Announcement.
    - Peru:
      - Tahu (2014): FX sales effective in reducing volatility and depreciation; FX purchases not effective.
    - Mexico:
      - Domac and Mendoza (2004): FX sale of US$ 100 million strengthens the peso by 0.08 percent.
      - Chamon (2015): Appreciation of about 2½ percent following 2015 FX Intervention Announcements.
    - Turkey:
      - Domac and Mendoza (2004): FX sale of US$ 100 million strengthens the lira by 0.2 percent.
- Practical guidance for intervention:
  - Sterilized foreign exchange sales have a stronger case when:
    - Exchange rate clearly overshoots equilibrium.
    - Currency mismatches are large.
    - Reserves are adequate.
  - Intervention to smooth gradual adjustment to a more depreciated equilibrium is costlier and can delay warranted adjustment; consider intervention mainly for financial stability or disorderly market conditions.
  - If reserves are barely adequate, intervention can be counterproductive.

- Transparency, communication, and policy recommendations on intervention
  - Current shortcomings:
    - Objectives for intervention often not clearly communicated; e.g., no country explicitly mentions level of exchange rate as an objective.
    - Lack of clarity on what constitutes “volatility” and on operational frameworks limits effectiveness.
  - Policy recommendations:
    - Make intervention objectives clearer (exchange rate levels, financial stability, reserve accumulation).
    - Clarify operational frameworks (rules vs discretion, triggers, instruments).
    - Increase transparency and communication so the private sector can infer central bank reaction functions and potentially reduce intervention needs.

### VIII. Central Banks and Systemic Financial Stability (Macroprudential)

- Historical context and recent resilience
  - Latin America experienced 28 systemic banking crises during 1970–2012; region ranks third in total number of crises, first in crises-per-country basis.
  - The region weathered the global financial crisis relatively well; disorderly conditions largely averted.
  - Financial systems in commodity-exporting countries resisted terms-of-trade deterioration and capital outflows linked to U.S. monetary policy normalization.

- Macroprudential policy developments and institutional arrangements
  - Chile, Mexico, Uruguay have formally established financial stability committees; Brazil created internal central bank arrangements and coordination committees.
  - Toolkit for macroprudential policy primarily comprises pre-existing regulatory instruments (dynamic provisioning in Bolivia, Colombia, Peru, Uruguay).
  - Brazil is the most active in implementing macroprudential instruments, using loan-to-value ratios and risk-weight factors.
  - Imposing extraordinary capital requirements on systemic financial institutions is not common, despite that in most countries the two largest banks together exceed 40 percent market share.

- Institutional models and challenges (Box 1 summary)
  - Two institutional models:
    - Atlantic model: Argentina, Brazil, Paraguay, Uruguay — central bank responsible for both monetary policy and prudential regulation and supervision.
    - Pacific model: Chile, Colombia, Mexico, Peru — central bank and separate agency carry out these responsibilities.
  - Common institutional features for Chile, Mexico, Uruguay:
    - Chile created the Financial Stability Council in 2011; Mexico the Financial System Stability Council in 2010; Uruguay the Financial Stability Committee in 2011.
    - Committees mandate: prevent systemic risk buildup and recommend macroprudential policies; generally lack binding decision powers and formal accountability (exception: Mexico must prepare and publish a financial stability report).
    - All three committees presided by the Minister of Finance; membership includes heads of supervisory agencies and the central bank (Chile: governor invited but not formally a member).
    - Required meeting frequency: Chile at least every month; Mexico at least quarterly; Uruguay at least once a year.
  - Key challenges:
    - Atlantic model: clarify legal mandate and accountability; distinguish objectives of macroprudential (financial stability) and monetary (price stability) policies.
    - Pacific model: distributed information and powers complicate implementation; committees often can only recommend, creating weak accountability.
    - Accountability dilemma: financial stability hard to measure; accountability risk devolves to blame assignment rather than prevention.
  - Recommendations for strengthening macroprudential frameworks:
    - Vest financial stability committees with “comply or explain” powers associated with recommending provisions to strengthen effectiveness.
    - Criteria to guide strengthening/establishing macroprudential policy:
      - (i) Achieve effective identification, analysis, and monitoring of systemic risk.
      - (ii) Ensure timely and effective use of macroprudential tools by creating appropriate mandates and assuring strong powers and accountability.
      - (iii) Ensure effective coordination in risk assessments and mitigation while preserving autonomy of separate policy functions.
    - Additional principles:
      - Do not undermine central bank independence and credibility.
      - Maintain distinct decision-making bodies with clear and separate objectives where appropriate (interest rates for monetary policy; macroprudential tools for financial stability).
      - Enhance communication to explain central bank roles in executing responsibilities.
  - Coordination guidance:
    - Use interest rates primarily to affect aggregate demand and achieve price stability.
    - Use macroprudential instruments primarily to achieve financial stability.
    - Institutional frameworks should enable effective coordination while recognizing unclear boundaries between macroprudential and microprudential policies.

- Policy challenge
  - Design effective macroprudential policy that preserves financial stability while minimizing costs and avoiding undermining central bank independence in monetary policy.

*Italicized source: Chapter 3 in Challenges for Central Banking: Perspectives from Latin America, edited by Y. Carrière-Swallow, H. Faruqee, L. Jácome, and K. Srinivasan. International Monetary Fund.*

### Chapter 3 in Challenges for Central Banking: Perspectives from Latin America, edited by Y. Carrière-Swallow,

### Chapter 3 in Challenges for Central Banking: Perspectives from Latin America

### I. Introduction
- The 2008 global financial crisis and its aftermath ushered in a new era of central banking worldwide, including in Latin America.
- Three central challenges for Latin American central banks are identified:
  - The traditional challenge of delivering price stability in a small group of economies where inflation remains stubbornly high and volatile; fiscal policy is often the root cause, and strengthening central bank independence is an important disinflationary strategy.
  - For countries with established and credible inflation-targeting frameworks, policymaking is complicated by unusually high uncertainty about the level and growth of potential output, the natural interest rate, and the equilibrium real exchange rate; improvements in communication, anchoring expectations, and clarifying the exchange rate and international reserves are needed.
  - Challenges from powerful external financial cycles and lessons from the recent financial crisis: external cycles can influence or overpower domestic monetary policy and destabilize financial systems, prompting reconsideration of central bank roles in financial stability and coordination between monetary and macroprudential policies.
- Paper organization:
  - Section II: progress and reversals in monetary policy.
  - Section III: refinements to improve inflation-targeting regimes.
  - Section IV: the role of the exchange rate and communication improvements.
  - Section V: implications of central banks’ role in financial stability.
  - Section VI: conclusions.

### II. Defeating Inflation—Achievements and Reversals

#### Central bank reform
- Since the 1990s, Latin American central banking transformed toward price stability, driven by:
  - Legal reforms granting independence to central banks.
  - Efforts to rein in public sector deficits.
  - Liberalization of external current and capital accounts, strengthened financial systems, and greater price discovery.
- Initial operational choices:
  - Many central bankers initially targeted the exchange rate (often via crawling peg or crawling band) to reduce inflation; later, countries adopted exchange rate flexibility and inflation targeting.
- Four pillars of new central banking legislation in the region:
  - (i) definition of a clear and narrow mandate;
  - (ii) formulation of central bank policies independent of the executive branch;
  - (iii) autonomy of monetary policy implementation;
  - (iv) accountability of central banks.
- Timeline of constitutional/legislative reforms (selected countries and years as described):
  - Chile: 1989 (pioneer).
  - El Salvador: 1991.
  - Argentina, Colombia, Ecuador, Nicaragua, Venezuela: 1992.
  - Mexico, Peru: 1993.
  - Bolivia, Costa Rica, Paraguay, Uruguay: 1995.
  - Honduras: 1996.
  - Dominican Republic, Guatemala: 2002.
  - Brazil: has not amended its central bank law since 1964 (exception noted).
- Variations in mandates and functions:
  - Price stability became the single or primary objective in most central banks (Table 1 referenced).
  - Some countries combine price stability with payments system operation (Chile, Honduras, Nicaragua) or banking regulation/supervision (Argentina, Brazil, Paraguay, Uruguay, Costa Rica, Mexico).
  - Brazil: use of monetary policy to promote economic development is not legally restricted; Argentina reintroduced that objective in 2012.
  - Venezuela: since 2001, central bank required to coordinate monetary policy with the government to “achieve the highest objectives of the State and the Nation.”
- Instrumental independence and restrictions on government financing:
  - Central banks were empowered to autonomously formulate exchange rate policy in most cases.
  - In some countries, central banks unilaterally set their inflation target.
  - Financing the government deficit was strictly restricted or banned constitutionally in Chile, Colombia, Ecuador, Guatemala, Mexico, and Peru, among others.
- Accountability mechanisms:
  - Central banks typically required to submit reports to the executive and legislative branches, publicly disclose decisions, and governors may be required to appear before Congress.

#### Measuring central bank independence in Latin America
- Legal independence increased significantly after reforms; measured by a modified index (based on Cukierman, Webb, and Neyapti (1992) with broader view), many central banks more than doubled their independence scores following reform.
- The modified index incorporates:
  - broader view of political independence (all board members),
  - central banks’ financial independence,
  - accountability and transparency.
- Among emerging markets, the most independent Latin American central banks now rank highly compared with peers in other regions.
- Empirical associations:
  - Greater central bank independence is associated with lower inflation (Jácome and Vázquez (2008)).
  - The study found a statistically significant positive correlation between structural reforms and legal central bank independence using panel regressions for 1985–2002, controlling for international inflation, banking crises, and exchange rate regimes.
  - Evidence of causality from legal central bank independence to inflation was not established; causality was found when using turnover rate of central bank governors as a measure of de facto independence.
- Table 2 (index values before and after reform) highlights specific country index changes (selected entries as listed):
  - Argentina* 1992: Pre-reform 0.31, Post-reform 0.83.
  - Bolivia* 1995: Pre-reform 0.33, Post-reform 0.83.
  - Brazil: (no reform year listed) — Brazil did not approve legislation to grant independence to the central bank.
  - Chile 1989: Pre-reform 0.26, Post-reform 0.85.
  - Colombia 1992: Pre-reform 0.29, Post-reform 0.83.
  - Mexico 1993: Pre-reform 0.39, Post-reform 0.81.
  - Peru 1993: Pre-reform 0.50, Post-reform 0.84.
  - Venezuela* 1992: Pre-reform 0.40, Post-reform 0.69.
  - Notes: * denotes countries where subsequent legislation has reverted these reforms to some extent.  denotes countries where subsequent legislation furthered central bank independence.

#### A new policy framework
- Central bank independence was not a precondition for inflation targeting but was seen as necessary for reducing inflation and achieving durable price stability.
- Exchange rate regime evolution:
  - Early autonomy phases often involved targeting the exchange rate via crawling pegs/bands to reduce inflation.
  - Currency crises in some countries and intellectual developments led to greater exchange rate flexibility by the early 2000s, enabling implementation of fully fledged inflation-targeting regimes.
- By 2015:
  - Ten of the 18 countries in the region had adopted a flexible regime, up from six in 1990.
  - Five countries still kept a soft peg.
  - Three countries used the U.S. dollar as legal tender.
- “Fear of floating” and interventions:
  - Exchange rate flexibility was initially met with skepticism; countries repeatedly intervened in FX markets to restrict flexibility and build reserves (Calvo and Reinhart (2002) termed this “fear of floating”).
  - As hedging markets developed and nominal uncertainty declined, costs of exchange rate volatility declined and volatility of Latin America’s exchange rates converged to that of advanced small and open economies (Figure 3 referenced).
- Strengthening international reserves:
  - Countries aimed to create buffers against recurrent real and financial shocks.
  - Notable examples: Bolivia and Peru increased international reserves—measured by gross reserves minus gold—to more than 30 percent of GDP by 2015 from less than five percent (text ends mid-sentence).

*Source: Chapter 3 in Challenges for Central Banking: Perspectives from Latin America, edited by Y. Carrière-Swallow, H. Faruqee, L. Jácome, and K. Srinivasan. International Monetary Fund.*

### 1990. By 2015, Brazil and Mexico had also boosted international reserves to 20 and 15

### _wp16197 - 1990. By 2015, Brazil and Mexico had also boosted international reserves to 20 and 15

### Reserve accumulation and the rise of inflation targeting
- By 2015, Brazil and Mexico had boosted international reserves to 20 and 15 percent of GDP, respectively.
- Reserve accumulation in most countries benefited from favorable external conditions associated with the supercycle in global commodity prices.
- As exchange rates became more flexible, inflation targeting became more prevalent in the region.
- Adoption patterns:
  - Gradual piecemeal introduction of transparency and accountability elements in most cases.
  - Brazil followed a “cold turkey” approach during its currency crisis in early 1999.
  - Chile and Colombia introduced inflation targeting in 1999; Mexico in 2001; Peru in 2002.
- Operational changes:
  - Brazil, Chile, and Colombia established a short-term interest rate as the operational target when introducing inflation targets.
  - Bank of Mexico adopted a policy rate as operational target in January 2008, replacing a borrowed reserves target (the so-called corto).
  - Peru moved to a policy rate as operational target in late 2003 after a gradual transition away from monetary aggregates; Peru also uses reserve requirements as a capital flow management measure.

### Inflation targets, decision making, communication, and transparency (LA5)
- LA5 countries: Brazil, Chile, Colombia, Mexico, Peru.
- Inflation targeting choices and communication practices (as reported in Table 3):
  - Brazil: 4.5% (+/-2); 8 per year policy meetings; Issue press release: Yes; Issue minutes: Yes; Publication of votes: Balance of votes; Inflation report: 4 per year.
  - Chile: 3% (+/-1); Monthly policy meetings; Issue press release: Yes; Issue minutes: Yes; Publication of votes: Balance of votes; Inflation report: 4 per year.
  - Colombia: 3% (+/-1); Monthly policy meetings; Issue press release: Yes; Issue minutes: Yes; Publication of votes: Majority/consensus; Inflation report: 4 per year.
  - Mexico: 3% (+/-1); 11 per year policy meetings; Issue press release: Yes; Issue minutes: Yes; Publication of votes: No; Inflation report: 4 per year.
  - Peru: 2% (+/-1); Monthly policy meetings; Issue press release: Yes; Issue minutes: No; Publication of votes: No; Inflation report: 4 per year.
- All LA5 central banks chosen a point target with a tolerance band using the consumer price index as the measure of price stability.
- All LA5 central banks issue a quarterly inflation report; all hold pre-announced monetary policy meetings, mostly monthly; Brazil and Chile provide information on how votes were cast; Peru does not issue minutes.

### Achieving low and stable inflation — outcomes and reversals
- Institutional and policy reforms led inflation to plunge across the region by the mid-1990s, with many countries achieving low and stable inflation during the mid-2000s.
- Persistent exceptions and recent high-inflation cases:
  - Venezuela: inflation has surged to triple digits.
  - Argentina: estimated to have averaged more than 30 percent since 2014.
  - As of mid-2016, Venezuela and Argentina displayed highest rates of inflation in the world per the text.
  - Brazil and Uruguay: inflation recently hovered around ten percent.
- Causes of high inflation in affected countries: deterioration in public finances and fiscal dominance, governments pressuring central banks to finance fiscal deficits, institutional weaknesses in central banks, lax fiscal policies, wage indexation.
- Policy implication: in high-inflation countries, consolidate central bank independence and strengthen fiscal frameworks to lay basis for price stability.

### Measuring the output gap and assessing the policy stance
- Output gap estimation challenges:
  - Potential output is unobservable; real-time estimates are subject to substantial revisions and judgment.
  - Real-time estimates tend to overestimate slack (bias toward overestimating slack), with initial diagnoses of slack often revised to overheating later.
  - Median revision to output gap during the first year: 0.9 percentage points; additional revisions after two years: almost 0.5 percentage points. This bias is larger during recessionary periods.
  - Revisions are smaller among advanced economies than emerging markets, and smaller among inflation-targeting countries.
- Commodity supercycle and potential output:
  - The end of the commodity price supercycle led to very large downward revisions to medium-term growth outlooks for Latin America and the Caribbean.
  - WEO (World Economic Outlook) vintages of medium-term growth for Latin America and the Caribbean (series shown in figure): 4.5, 3.4, 4.2, 2.8, 2.5, 3.0, 3.5, 4.0, 4.5, 5.0 (as reported in the figure sequence).
- Neutral real interest rate considerations:
  - Highly accommodative global financial conditions since the 2009 crisis and global savings glut estimated to have systematically and substantially lowered the neutral real interest rate in Latin America.
  - Neutral rate expected to be increasing function of potential output growth and the international neutral rate; slowing potential growth and declining advanced-economy neutral rate may reduce neutral interest rates in Latin America.
  - A steady policy rate may in fact correspond to a gradually tightening monetary stance if neutral rates are falling.

### Anchoring expectations and communication
- Credibility improvements have helped anchor inflation expectations, which is crucial for monetary transmission.
- Deviations of inflation expectations from targets (examples cited):
  - Brazil: inflation expectations exceeded the central bank’s target for the past six years, reaching deviations of up to 250 basis points at a one-year horizon during 2015.
  - Peru: inflation expectations above the target since early 2010, settling around 75 basis points above the midpoint of the range.
  - Mexico: market participants have not expected inflation to reach the central bank’s target in a two-year horizon since early 2006.
- Disagreement among professional forecasters of 12-month-ahead inflation has declined since early 2000s and is in line with advanced economies such as Australia and Canada, indicating improved agreement among private agents even when forecasts do not coincide with central bank targets.
- Policy recommendation: improve central bank communication of monetary policy and clarify the primacy of price stability to facilitate convergence of expectations.

### Exchange rate role, depreciations, and monetary policy trade-offs
- Recent external shocks:
  - Large exchange rate depreciations triggered by shifts in global commodity prices and financial conditions (start dates: June 2014 for oil producers Brazil, Colombia, Mexico; March 2013 for metals producers Chile and Peru).
  - Recent depreciations in most cases among the largest since shift to more flexible regimes (except Peru).
  - Depreciations have been prolonged (over two years) compared to the relatively short-lived 2008 Lehman episode.
- Monetary policy trade-offs faced by inflation-targeters:
  - Option (i): Keep policy supportive of weak aggregate demand, tolerate inflation above target for some time — requires credible anchoring of inflation expectations.
  - Option (ii): Implement procyclical monetary tightening to offset currency-driven inflation — risks worsening economic slack.
- Time horizon flexibility:
  - Central banks may need to be more flexible regarding the horizon to commit to returning inflation to target when confronted by multiple shocks moving inflation in same direction.
  - Example: Bank of England commits to returning inflation to its target “within a reasonable time period,” normally interpreted as two to three years.
- Two mitigating factors limiting inflation pressure from depreciations:
  1. Decline in exchange rate pass-through coefficients across Latin America, particularly among inflation targeters; in Chile, Colombia, Mexico, and Peru pass-through fallen to levels in line with advanced economies.
  2. Many trade partners also experienced depreciations in a strong U.S. dollar environment, so multilateral exchange rate movements were smaller than bilateral USD depreciations.

### Foreign exchange intervention: motives, frameworks, instruments, and evidence
- Typical objectives for foreign exchange intervention:
  - (i) Price stability (contain depreciation to avoid pass-through inflation).
  - (ii) Financial stability (limit excessive volatility and address currency mismatches).
  - (iii) Buffer building (accumulate international reserves for precautionary purposes).
- Theoretical channels through which intervention may affect exchange rates:
  - Signaling (convey future monetary policy intentions).
  - Portfolio balance channel (sterilized intervention changes relative supplies and risk premia).
  - Market microstructure (trading volume and volatility dynamics).
  - Precautionary saving channel (reserve accumulation after crises).
- Regional practices and trends:
  - Inflation-targeting central banks in Latin America use intervention subordinated to interest rate policy to react to large movements and excessive volatility.
  - LA5 central banks accumulated substantial international reserves during 2010–2015; Brazil accumulated up to about 7 percentage points of GDP in that period (Figure 9).
  - Reserve accumulation should be sterilized to avoid higher inflation that could de-anchor expectations.
- Intervention frameworks:
  - Rules-based frameworks (e.g., Colombia and Mexico previously used rules conditioned on large daily changes; Brazil briefly used a pre-announced program during the “taper tantrum”).
  - Discretionary intervention (e.g., Brazil outside the pre-announced program, Peru, and more recently Colombia and Mexico).
  - Brazil’s pre-announced program (August 2013 onward) involved daily auctions of foreign exchange swaps and repos equivalent to US$ 3 billion per week; at peak foreign exchange outstanding balance was about US$ 110 billion.
- Instruments and typical uses:
  - Spot interventions: used mostly by Chile, Colombia, Mexico for financial-stability objectives and to address liquidity shortages.
  - Swaps / non-deliverable forwards: used by Brazil and Peru; swaps useful for hedging demand and to mitigate changes in international reserves.
- Frequency and predictability:
  - Rules-based interventions make frequency partially predictable; discretion-based interventions make frequency less predictable and can amplify instability.
  - Greater transparency and clearer communication can reduce the need to intervene and mitigate market microstructure effects.
- Empirical evidence on effectiveness:
  - Mixed evidence on intervention reducing volatility and affecting exchange rate levels.
  - Recent empirical literature on emerging markets finds some supportive evidence that sterilized intervention reduced pace of appreciation when responding to capital inflows (e.g., Adler and Tovar (2014), Adler, Lama, and Medina (2016), Daude, Levy-Yeyati, and Nagendgast (2014)).
  - Country studies: IMF (2015) shows intervention reduced volatility in Brazil during 2013 “taper tantrum”; Tashu (2014) finds intervention effective in reducing volatility in Peru; Domac and Mendoza (2004), Chamon (2015), IMF (2015) find similar evidence in Mexico. Claro and Soto (2013) find reserve purchases in Chile in 2008 and 2011 successful but not cost-free.
  - Other studies report limited or small effects in some contexts (e.g., Disyatat and Galati (2005) for Czech Republic; Barroso (2014) and Chamon, Candido de Souza, and Garcia (2015) describe limited appreciation impact in Brazil).
  - Nedeljkovic and Saborowski (forthcoming) find both spot and non-deliverable futures effective in affecting level and volatility of Brazil’s exchange rate; Brazil tends to rely more on spot to contain capital flow pressures and futures to impact trend.
- Practical guidance for intervention:
  - Sterilized foreign exchange sales have stronger case when exchange rate clearly overshoots equilibrium, currency mismatches large, and reserves adequate.
  - Intervention to smooth gradual adjustment to a more depreciated equilibrium is costlier and can delay warranted adjustment; consider intervention mainly for financial stability or disorderly market conditions.
  - If reserves are barely adequate, intervention can be counterproductive.

### Transparency, communication, and policy recommendations on intervention
- Transparency and clear communication are key to aligning foreign exchange intervention with inflation-targeting regimes.
- Current shortcomings:
  - Objectives for intervention often not clearly communicated (e.g., Adler and Tovar (2014) found reducing excess volatility most stated motive, but not a single country explicitly mentioned level of exchange rate as an objective).
  - Lack of clarity on what constitutes “volatility” and on operational frameworks limits effectiveness.
- Policy recommendations:
  - Make intervention objectives clearer (exchange rate levels, financial stability, reserve accumulation).
  - Clarify operational frameworks (rules vs discretion, triggers, instruments).
  - Increase transparency and communication so private sector can infer central bank reaction function and anticipate interventions, potentially reducing actual intervention needs and improving inflation-targeting effectiveness.

### Central banks and systemic financial stability (macroprudential)
- Latin America experienced large and recurrent banking crises historically: 28 systemic banking crises during 1970–2012; region ranks third in total number of crises, first in crises-per-country basis.
- Recent resilience:
  - Latin America weathered the global financial crisis relatively well; disorderly conditions largely averted.
  - Financial systems in commodity-exporting countries resisted terms-of-trade deterioration and capital outflows linked to U.S. monetary policy normalization.
- Macroprudential policy developments:
  - Latin American countries have been cautious and slower than advanced economies in developing macroprudential frameworks.
  - Chile, Mexico, Uruguay have formally established financial stability committees; Brazil created internal central bank arrangements and coordination committees.
- Policy challenge:
  - Design effective macroprudential policy that preserves financial stability while minimizing costs and avoiding undermining central bank independence in monetary policy.

*Italicized source: IMF staff analysis and country case descriptions as provided in the source content.*

### Box 1: Financial Stability Committees in Chile, Mexico, and Uruguay

### Box 1: Financial Stability Committees in Chile, Mexico, and Uruguay

### Overview
- Chile created the Financial Stability Council in 2011, Mexico the Financial System Stability Council in 2010, and Uruguay the Financial Stability Committee in 2011.
- These institutional arrangements aim to prevent the buildup of systemic risks and to recommend macroprudential policies to relevant agencies, while generally lacking decision powers and formal accountability.

### Mandate and Powers
- Common features:
  - Mandate to prevent the buildup of systemic risks and to recommend macroprudential policies to relevant agencies.
  - No decision powers and not held accountable (exception: in Mexico, the Council is required to prepare and publish a report assessing financial stability and the measures taken).
  - Powers to obtain information from all financial industries and participating institutions.
  - Coordinating role to secure consistency of financial stability efforts.
- Crisis management:
  - Mexico and Uruguay: financial stability committees have explicit powers to manage financial crises.
  - Chile: crisis management powers reside with individual institutions; the Council operates as a coordinating device. Crisis management is explicitly mentioned as a key consideration for establishing the Council.

### Membership and Structure
- All three committees are presided by the Minister of Finance (MoF) and include heads of financial supervisory agencies and the central bank, with exceptions:
  - Chile: the governor of the Central Bank of Chile is invited to participate but is not formally a member of the Council (not formally a member because this was seen to conflict with the independence and mandate of the central bank, as sanctioned in the Constitution).
- Mexico — Financial System Stability Council composition includes:
  - the head of the National Commission of Banks and Securities;
  - the National Commission of Insurances;
  - National Commission for the Savings for Retirement;
  - the Executive Secretary of the Institute of Banks Saving Protection;
  - the Undersecretary of Finance;
  - the Governor of the Bank of Mexico and two Deputy Governors.
- Uruguay — Financial Stability Committee comprises:
  - the Governor of the Central Bank of Uruguay;
  - the Superintendent of Financial Services;
  - the President of the Corporation for the Protection of Banks Savings.
- Chile — Financial Stability Council comprises:
  - the head of the Superintendence of Securities and Insurances;
  - the Superintendence of Banks and Financial Institutions;
  - the Superintendence of Pensions.

### Specific Responsibilities and Meeting Frequency
- Additional responsibilities:
  - Chile: recommending criteria for the determination of the budget of the supervisory agencies.
  - Uruguay: coordinating with other international institutions on issues of financial stability.
- Required meeting frequency:
  - Chile: at least every month.
  - Mexico: at least quarterly.
  - Uruguay: at least once a year.

### Regional context and practice
- The toolkit for macroprudential policy in Latin America is primarily comprised of pre-existing regulatory instruments (examples in the region include dynamic provisioning in Bolivia, Colombia, Peru, and Uruguay).
- Brazil is noted as the most active country in implementation of macroprudential instruments, using changes in loan-to-value ratios and risk-weight factors.
- Imposing extraordinary capital requirements on systemic financial institutions is not common in Latin America, despite that in most countries the two largest banks have a market share that together exceeds 40 percent.

### Institutional models and challenges
- Two institutional models:
  - Atlantic model (Argentina, Brazil, Paraguay, and Uruguay): central bank responsible for both monetary policy and prudential regulation and supervision.
  - Pacific model (Chile, Colombia, Mexico, Peru, among others): central bank and a separate agency carry out these responsibilities.
- Key challenges:
  - Atlantic model: clarify legal mandate and establish clear accountability; distinguish objectives of macroprudential policy (financial stability) and monetary policy (price stability); coordinate systemic risk efforts with supervisory agencies.
  - Pacific model: information, expertise, and regulatory powers are distributed across agencies, complicating macroprudential policy implementation; financial stability committees in some countries can only recommend, not bind, creating weak accountability.
  - Accountability dilemma: financial stability is hard to measure; accountability based on instability risks devolving to blame assignment rather than prevention.

### Recommendations and criteria for strengthening macroprudential frameworks
- Possible institutional enhancement:
  - Vest financial stability committees with “comply or explain” powers associated with existing recommending provisions to strengthen effectiveness.
- Criteria to guide strengthening or establishing macroprudential policy:
  - (i) Achieving effective identification, analysis, and monitoring of systemic risk.
  - (ii) Ensuring timely and effective use of macroprudential policy tools by creating appropriate mandates and assuring strong powers and accountability.
  - (iii) Ensuring effective coordination in risk assessments and mitigation to reduce gaps and overlaps while preserving the autonomy of separate policy functions.
- Additional principles:
  - Do not undermine central bank independence and credibility.
  - Maintain distinct decision-making bodies with clear and separate objectives where appropriate (interest rates for monetary policy; macroprudential tools for financial stability).
  - Enhance communication to explain central bank roles in executing responsibilities.

### Coordination with monetary and microprudential policies
- Monetary and macroprudential policies:
  - Strong complementarities and interactions exist; no standard recipe for effective coordination.
  - Principle: use interest rates primarily to affect aggregate demand and achieve price stability; use macroprudential instruments primarily to achieve financial stability.
- Macroprudential and microprudential policies:
  - Different primary objectives (system-wide stability vs. protection of depositors) but can conflict because they can use similar instruments.
  - Institutional frameworks should enable effective coordination while recognizing unclear boundaries between the two policy types.

_Italic: Box 1: Financial Stability Committees in Chile, Mexico, and Uruguay — source content from the provided PDF excerpt._

### References

### _wp16197 - References

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### Appendix: Some empirical evidence on foreign exchange interventions
- Cross country findings:
  - Adler and Tovar (2014): 0.1 of GDP FXI slows down the pace of domestic currency appreciation by 0.3 percent.
  - Adler, Blanchard, and Carvalho (2015): 0.25 percent of GDP FXI reduces appreciation on impact by 1.5 percent.
  - Adler, Lisack, and Mano (2015): 1 percentage point of GDP FXI depreciates the nominal and real exchange rates by [1.7–2.0] percent and [1.4–1.7] percent, respectively.
  - Daude, Levy-Yeyati, and Nagengast (2014): 1 percent increase in FXI weakens the domestic currency by 0.18 percent.
- Brazil:
  - Barroso (2014): US$ 1 billion buy intervention => 0.45–1.18 percent depreciation. US$ 1 billion selling intervention => 0.46–0.66 percent appreciation. Average: 0.5 percent change in domestic currency valuation.
  - Chamon, Garcia, and Sousa (2015): Appreciation in excess of 10 percent following the 2013 Swap Program Announcement.
- Peru:
  - Tahu (2014): FX sales effective in reducing volatility and depreciation. FX purchases not effective.
- Mexico:
  - Domac and Mendoza (2004): FX sale of US$ 100 million strengthens the peso by 0.08 percent.
  - Chamon (2015): Appreciation of about 2½ percent following 2015 FX Intervention Announcements.
- Turkey:
  - Domac and Mendoza (2004): FX sale of US$ 100 million strengthens the lira by 0.2 percent.

*Source: _wp16197 - References*

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