Taming the Monster

• Author: Agustín Carstens and Luis I. Jácome H.
• Position: Deputy Managing Director of the IMF/Senior Economist in the IMF's Monetary and Financial Systems Department and Adjunct Associate Professor at Georgetown University

How Latin America's central banks survived hyperinflation to become guardians of price stability

In 1990, average inflation in Latin America reached an unprecedented 500 percent. Argentina, Brazil, and Peru-three of the region's largest economies-posted four-digit rates of inflation, and no country managed to achieve inflation below 10 percent. As standards of living suffered, governments undertook far-reaching structural changes-including central bank reform-that eventually provided the underpinnings needed to wage a successful war on inflation.

Today, inflation has been brought down to single-digit territory in most countries in Latin America. Central banks have played a key role in achieving this turnaround, but they still need to address at least three important challenges. First, most central banks have yet to achieve price stability. Second, in a number of countries, central banks need to restore market confidence in domestic currencies. And third, central banks have to maintain policy consistency in the face of volatile capital flows. Recurrent banking crises and lax fiscal discipline may threaten their ability to meet these challenges.

Mapping central bank reform

Starting with Chile in 1989, almost all Latin American countries have approved legislation that grants central banks enhanced autonomy in return for greater accountability. These reforms pursue four goals, prioritized differently across countries:

· a clear mandate to pursue price stability rather than economic growth (which used to be the primary goal);

· political autonomy to formulate monetary policy, which has had the effect of untying policymaking from electoral calendars;

· operational autonomy to conduct monetary policy without restrictions, including the ability to set interest rates without government interference and strict limitations-sometimes even prohibitions-on financing fiscal deficits; and

· accountability for achieving inflation targets.

These institutional changes have, in most countries, been complemented by a change of monetary policy regime. Over the past 10 years, most central banks migrated from exchange rate pegs to flexible arrangements. At the beginning of the 1990s, with inflation in the region hovering around triple digits, most countries embarked on stabilization strategies based on an exchange rate anchor supported by growing capital inflows. In practice, this meant that most central banks abdicated-or at least strongly restricted-their ability to conduct monetary policy. But a string of systemic financial crises, sometimes combined with excessively expansionary fiscal policies, eventually led to the collapse of exchange rate pegs in Argentina, Brazil, Ecuador, Mexico, Uruguay, and Venezuela.

The transition to exchange rate flexibility was traumatic and was accompanied by swift and steep devaluations. To restore a nominal anchor, central banks in Brazil, Chile, Colombia, Mexico, and Peru introduced inflation targeting in the late 1990s and early 2000s. The new legislation allowed central banks to formulate monetary policy with a clear objective, based on independent and...