URUGUAY: TWO YEARS OF MONETARY POLICY IN ADVERSE CONDITIONS

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URUGUAY TWO YEARS OF MONETARY POLICY IN ADVERSE
CONDITIONS

• Daniel Dominioni
• Central Bank of Uruguay
• Atlanta, October 2.004
• The views expressed in this paper do not
  necessarily represent those of the Central Bank

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• The macroeconomic context
• The monetary policy after June 2.002
• Today challenges

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The macroeconomic context
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The macroeconomic context

• Inflation in Uruguay
• Dollarization
• The crisis of 2.002

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Inflation

• Stabilization plans
• 1968
• 1978
• 1990
• All with exchange rate anchor
• The last one was the most successful

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Dollarization

• 90 of financial intermediation is in US dollars.
• Before the crisis all the public debt was
  nominated in foreign currency

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2.002 The crisis

• Reversion of capital flows to the region
• Argentinas financial collapse
• Brazils devaluation
• Terms of trade fall
• Foot and mouth disease
• Internal vulnerabilities
• Dollarization
• Rigidities in prices
• Fiscal vulnerability

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Consequences of the crisis (I)

• Decrease in GDP
• 1999 -2.8
• 2000 -1.4
• 2001 - 3.1
• 2002 -11.0
• In dollar terms 2.002 GDP is 55 of 1998 GDP.
• Unemployment reached 19.8 (November 2.002)

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Consequences of the crisis (II)

• 40 of deposits left the banking system
• International reserves dropped from 31 billion
  to 07 billion
• Foreign currency term deposits of public banks
  frozen and reprogrammed to 3 years.
• Four (large) domestic banks closed

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Consequences of the crisis (III)

• FISCAL DEFICIT (in terms of GDP)
• 1999 4.0
• 2000 4.1
• 2001 4.2
• 2002 4.0
• PUBLIC DEBT (in terms of GDP)
• gross net
• 1999 42 30
• 2000 48 34
• 2001 58 41
• 2002 92 66

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Consequences of the crisis (IV)

• Band of flotation was abandoned (June 2.002)
• Exchange rate grew almost 70 in 4 months and
  prices 16 in the same period
• Economy without nominal anchor

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Monetary policy after June 2.002
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Challenges of the new policy

• Economy in deep crisis
• Lack of credibility
• High degree of dollarization
• Lack of experience in monetary policy
• Problems for estimating a demand for money
  function
• Unpredictability and instability of money
  multiplier
• Fiscal dominance

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The choice of a new nominal anchor

• Exchange rate
• International reserves very low
• Reversion of dollarization as an objective
• Interest rate
• small size of markets of instruments in national
  currency
• dollarization
• transmission channels closed
• Monetary aggregates

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The basics of monetary policy

• Goal the achievement of a reasonable level of
  inflation
• Intermediate objective M1
• Operational intermediate target monetary base
• Reversion of the rationale of programming
  exchange rate endogenous
• not easy to understand by the public

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The projection
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The projection main results

• Good results in terms of usual tests
• No evidence of structural change
• Stable relationship between variables
• Parameters all significant with expected signs
  and values
• long run elasticity with respect to the product 1
• semi-elasticity with respect to interest rate
  -0.5
• tendency decrease of the demand for money 0.7
  per quarter
• short run money holdings are increased in 44 of
  the excess demand for the previous quarter

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The projection main problems (I)

• Variables used available only on quarterly
  average of end of month basis
• Standard deviation of parameters very high (3.7)
• Equation not invertible
• No good specified price equation

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The projection main problems (II)

• Monetary base and M1 series available with
  different frequencies.
• M1 end of month
• Monetary base daily
• Targets on monetary base are set on quarterly
  average of daily values
• High volatility of the multiplier
• the coefficients that compose it are estimated
  separately making reasonable assumptions

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The implementation

• Central Bank announces the intermediate operative
  target one year ahead
• Commitment for the next quarter
• Projection revised each quarter
• Exogenous factors of monetary base variation are
  estimated
• net purchases of foreign currency
• credit to the Government (restricted by law)
• use of Government deposits in Central Bank
• defifict of Central Bank in local currency
• Central Bank bills are issued to achieve the
  target

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The evolution of monetary policy

• 1) Until the end of 2.002 put the house in order
• 2) 2.003 Commitment to the monetary base
• 3) 2.004 More commitment to prices

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Until the end of 2.002 put the house in order (I)

• Inflation rose up in July (4.9), August (5.8)
  and September (3.1)
• Turbulences in the market
• Goal prevent inflation from jumping further
• Monetary policy limited to sterilization of money
  increase due to Government expenditure
• Average maturity of financing and sterilization
  instruments was less than 1 month
• Three-digit interest rates

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Until the end of 2.002 put the house in order
(II)

• Elaboration of a new framework for monetary
  policy
• Succesful policy Inflation kept at manageable
  levels

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2.003 Commitment to the monetary base (I)

• Two relevant events
• Renegociation of public debt
• Recovery of level of activity
• More favorable environment
• Goals of the Central Bank
• Regain credibility
• Effective control of monetary base
• Recomposition of international reserves
• Dedollarization of the economy

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2.003 Commitment to the monetary base (II)

• December 2.002 announcement of monetary base
  trajectory one hear ahead
• Important efforts made to send a message that the
  Central Bank was able to put an anchor on one
  nominal variable
• At the end of the cuarter
• Goals evaluated and eventually revised
• Another quarter added to forecast
• Core inflation measures and time series analysis
  used to evaluate the nature of deviations

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2.003 Commitment to the monetary base (III)

• Measures to improve transparency
• May Central Bank stopped buying foreign currency
  in order to sell it to the Government
• June Monetary and Government financing
  instruments are distinguished
• November
• foreign currency is purchased using acutions.
• Ammount to be purchased is announced at the
  beginning of the day and the month (in 2.004
  announcement for the whole year also)

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2.003 Commitment to the monetary base (IV)

• Measures to improve communication
• Monetary base informed dialy
• Monthly reports
• Quarterly reports
• Evaluation of the goals
• Explanation of the reviews
• Workshops with private analysts

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2.003 Commitment to the monetary base (V)

• Objective inflation between 17 and 23
• Monetary base target always met
• Actual inflation below projected (10.7)
• Output gap
• Reluctance of banking system to expand the credit
• Increase in money demand
• Faster than expected recovery
• More confidence

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2004 more commitment to stability

• Expectations of inflationary pressures
• Increases in tradables (oil, meat)
• Reduction of output gap
• Uncertainty because of elections
• More commitment to price stabilization
• Compromise with monetary base relaxed
• Range of values for its path
• Preparing the field to inflation-targeting

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The development of new instruments (I)

• Goals in terms of monetary base always achieved
• Goals reached using very simple instruments
• Expansion
• Issue of bills
• Contraction
• Not revolving bills
• Buying international reserves
• Monetary policy very expensive

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The development of new instruments (II)

• Causes of limited number of instruments
• Dollarization
• Extended use of exchange rate anchors in the past
• Underdevelopped markets for derivatives
• Markets of national currency nominated
  instruments not depth

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The development of new instruments (III)

• Gradual introduction of new instruments
• April 2.004 repo facility was introduced
• August 2.004 Central Bank implemented forward
  contracts in the exchange market
• Other instruments under evaluation
• Open market operations in secondary markets
• Discount window (punishment rates?)
• Instruments to reduce volatility of exchange rate
  or rate of interst

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TOWARDS AN INFLATION-TARGETING REGIME ?
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Towards an inflation-targeting regime?

• Are we prepared ?
• What kind of inflation targeting regime ?

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Are we prepared ? (I)

• A non credible policymaker may have to tie
  himself firmly to the mast to get any results
  (Guillermo Calvo)
• Central Bank is very cautious in its
  communication strategy
• More commitment with prices doesnt mean
  inflation targeting
• The cornerstone of the strategy is the building
  of credibility

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Are we prepared ? (II)

• Inflation should be under control before the
  implementation of a IT regime
• Institutional framework must be improved
• Independence of Central Bank
• Transparency
• Accountability
• Strong commitments
• Clear rules
• Credibility

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Are we prepared ? (III)

• Some progresses in the institutional framework
  Charter of Central Bank (1995)
• Defense of the currency value is one objective of
  the Central Bank
• Limits to the ability to finance the Government
• Conditions for giving assistance to the banking
  sector

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What kind of inflation targeting ? (I)

• Pure or flexible ?
• Two reasons for targeting only inflation
• To achieve a modest impact on output the Central
  Bank will have to increase inflation in a big
  amount
• Inflationary bias (not enough reputation)
• When more reputation is achieved IT could be more
  flexible

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What kind of inflation targeting ? (II)

• What instrument ?
• Neither interest rates nor monetary aggregates
  are good instruments
• Temptation to use the exchange rate
• Promotes dollarization
• Deepens path-through
• Lack of flexibility in a sudden stop
• Interest rate as a signal ?

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What kind of inflation targeting ? (III)

• What index to target CPI or core?
• Escape clauses ?
• For credibility the easier the index the better
  it is

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What kind of inflation targeting ? (IV)

• The problem of rigidity of prices
• A low target for inflation requires a drop in non
  tradable prices when there is an increase in
  equilibrium real exchange rate
• Can deepen a recession in a sudden stop

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What kind of inflation targeting ? (V)

• Posible solutions to the rigidity problem
• Target long run inflation
• Target prices, not inflation rate
• Target non-tradable inflation

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What if inflation targeting fails ? (VI)

• Could full dollarization be a solution?