Central bank independence - what role does it play in shaping Mexico's economy?
Speech by Malcolm Knight, General Manager of the BIS, at a conference on "Stability and economic growth: the role of the central bank", organised by the Bank of Mexico to commemorate its 80th birthday, Mexico City, 14-15 November 2005.
Mr Knight discusses the role of the Banco de México's legal and governance arrangements in Mexico's post-crisis stabilisation. He argues that there are good grounds for believing that the monetary stability Mexico has achieved in recent years is sustainable. He notes that a well structured legal framework was put in place almost as the crisis was unfolding, but that it took time to develop an effective inflation targeting framework that clarifies objectives, focuses transparency and facilitates accountability. He also discusses some risks that could arise if well anchored inflation expectations are taken for granted. External events too may create some challenges in years to come.
It is a pleasure and an honour to be invited to join you in celebrating the Bank of Mexico's 80th anniversary. There is indeed much to celebrate. Mexico's economy continues to grow. Inflation has fallen steadily, and is now around 3%. There are many signs of increasing confidence in the future - and the country is now an investment grade credit.
This anniversary is a happier occasion than the 70th birthday in 1995, when the country was in the throes of a major economic and financial crisis. Inflation was then running at 35% a year and output fell by 6%. This crisis led to deep changes in economic policy arrangements that laid the foundation for Mexico's current good performance. But it is sometimes forgotten that previous crises were also followed by economic policy reforms. On those occasions, too, growth returned and confidence about future prospects improved.
Is Mexico now better placed to avoid a repeat cycle of optimism and collapse? I think most observers would agree that the answer to this question is "yes". One reason is the degree of fiscal consolidation Mexico has achieved in recent years. It is difficult to overstate the importance of this improvement for the stability of the country's economy. Governments should not, of course, forget that public debt ratios are still high in Mexico and that action to reduce deficits is best taken when the economy is growing strongly.
Another reason - and this is the focus of my speech - is that reforms to the governance arrangements for monetary policy, initiated just before the 1994 crisis, have since succeeded in creating a new climate of monetary stability. I want to stress that these reforms were not just a one-off, but were followed by continued efforts to improve Mexico's monetary framework. At the same time, I would also like to suggest that continued vigilance is needed, even as the memory of instability fades.
Sustainable monetary stability
What evidence is there that these reforms really "worked"? The answer is that Mexico has achieved what I would call "sustainable monetary stability".
The most obvious sign of monetary stability is that inflation is now at its lowest level in living memory. Two aspects of the circumstances surrounding the current low inflation rates suggest that monetary stability is sustainable.
The first is that it has been achieved with a genuinely flexible exchange rate. There have been periods in the past when inflation in Mexico was held down by a fixed or quasi-fixed exchange rate - as it was for instance, in the early 1990s. But once the exchange rate collapsed, inflation shot up. I well remember being told by Mexican economists at the time that it was movements in the exchange rate which dominated inflation expectations. In short, there was no convincing domestic nominal anchor.
But with the advent of a flexible exchange rate - combined with a credible inflation target - the exchange rate eventually ceased to dominate the inflation process. Indeed, the evidence in recent years is that the short-term pass-through of exchange rate changes to inflation has been much reduced. In other words, the monetary policy commitment to low inflation has come to provide a domesticanchor for inflation expectations. And in the last couple of months we have witnessed something rather extraordinary - Mexican short-term interest rates have fallen while the US federal funds rate has risen. It will be interesting to see how far these rate movements remain disconnected in the months ahead.
The second reason for seeing recent monetary stability as sustainable is the remarkable development of the peso-denominated bond market. Not so long ago, many would have said that such a development would be impossible - that Latin America was condemned to depend on dollar-denominated debt. But it has been achieved here in Mexico, and at progressively lower interest rates.
The nominal yield on five-year peso bonds is now around 10%, compared with 15% in 2000. What is even more significant is that longer-maturity yields have changed little despite the significant rise in short-term rates that took place over the period to April of this year. These developments are convincing evidence of confidence in the domestic currency as a store of value - so long missing in Mexico. It is, one might say, a vote of confidence not only in current monetary policy but also in future monetary policy.
Such a vote of confidence embodies a judgment that the governance arrangements now in place for monetary policy will continue to deliver low inflation. The consequence is that currency mismatches have been reduced - and this country is therefore less exposed to exchange rate shocks. This helps to support exchange rate flexibility. It means that Mexico is now much better placed to weather the shocks that come with the increased internationalisation of the economy.
To sum up: there is, I believe, a good deal of evidence that monetary stability in Mexico is sustainable. This, I would argue, is thanks to more effective governance arrangements for monetary policy.
The Central Bank Law of early 1994 laid a legal foundation that was particularly well conceived. The governor was to be appointed for a fixed term, and this has helped provide insulation from the political cycle. In addition, staggered terms of office for other board members have helped to ensure continuity. Measures were also taken to ensure that the Bank's financial base could not be undermined.
Yet this law was not enough on its own to achieve credibility. All laws require supporting practices and procedures to bridge the gap between legal form and substantive reality. They take time to develop. In addition, the crisis of 1994-95 came at the worst possible time for building credibility in the new law. The central bank had to prove by deeds over several years that it would bring inflation down even in difficult circumstances.
This was a long process. Two elements were key. The first was the move towards a genuinefloating exchange rate. The well known operating rules that were developed to make the Bank of Mexico's operations in forex markets non-discretionary and transparent are an important reflection of this. They allowed the Bank of Mexico to build up its official reserves without giving the market a signal about any specific central bank objective for the level of the exchange rate. Indeed, the exchange rate was not an objective. Instead, the market, not the central bank, became responsible for setting the day-to-day value of the peso exchange rate.
The second key element was the phased adoption of an inflation targeting regime. Beginning in 1999, a fully fledged inflation target became the focal point of monetary policy. These quantitative inflation targets were progressively lowered. The present target of a rate of inflation of 3% with a band of 1 percentage point on either side reflects an ambition that would have seemed quite unrealistic only a few years ago.
The inflation targeting regime has supplemented the legal framework in three crucial ways:
- First, there is now greater clarity about the objective that guides monetary policy decisions. As I have mentioned, the exchange rate is no longer an explicit objective along with inflation controls as it was back in 1994. The goal of monetary policy now is to achieve a low, stable, and predictable rate of inflation. In implementing and explaining this monetary policy target, clarity is essential. Mixed or unclear objectives all too often lead to trouble. This clear objective helps to nurture confidence. It also helps to hold the central bank to account - a point I shall return to in a minute.
- Second, the Bank of Mexico has a strong measure of independence from the day-to-day political process. Crucially, decisions on the period-to-period setting of monetary instruments are now guided by objectives that are easily understood by private participants in the financial markets. This is particularly important to reassure markets in periods of heightened political uncertainty just before elections.
- There is a third, and critical, feature of a sound monetary policy framework which is also evident in the new arrangements - the requirement that the Bank of Mexico account for its policy actions.
Let me elaborate briefly on this third element, the need for central banks to provide an accurate public accounting of their monetary policy decisions.
Monetary policy inevitably involves judgment - in reading the current macroeconomic situation; in assessing the trade-offs that condition how quickly an inflation target is met; in determining the workings of particular monetary policy instruments. Proper assessment of monetary policy therefore requires decision-makers to tell the public about the analysis underlying their decisions and about their assessment of the uncertainties that are always present. This is why the Bank of Mexico's quarterly inflation reports are so important.
The requirement to account for actions can also play a powerful role in shaping financial market prices, and indeed prices and wages throughout the economy. The expectations of the public, and thus their actions, depend on their understanding of what motivates monetary policy decisions, now and in the future.
This is well understood at the Bank of Mexico. Policy decisions are regularly explained to the public with reference to the current and prospective economic circumstances within which the decisions are taken, and with reference to the central bank's interpretation of its policy mandate. Better than before, the Bank of Mexico's decision-makers know what they need to do. More easily than before, the public are able to observe policy actions and assess their consistency with stated objectives. This was hardly the case in 1994. These are the reasons for my confidence that the return to stability achieved over the past decade is likely to last.
One final aspect of governance that is also relevant for the central bank's contribution to national economic goals concerns its role in relation to matters outside its direct mandate. Many central banks can now take decisions on the monetary policy stance, appropriately constrained by the framework and the requirement to be accountable. But there are many aspects of economic policy relevant to monetary policy (and to financial stability) that are outside the control of the central bank. Exchange rate policy, fiscal policy settings, regulatory policy and tax policy as it affects financial markets and institutions, and government signals with respect to the willingness to rescue failing enterprises, are all matters of considerable significance for the central bank's own area of responsibility. Yet they are all matters where others have control or a significant say.
Dealing with such issues requires a delicate balancing act. Continual dialogue with government is clearly essential, but too close an identification could undermine accountability and credibility. My view is that central banks should aim to act as "wise counsel" in matters where their expertise is relevant and where their direct mandate is affected. To do so while maintaining effective operational independence on monetary policy, and preserving their credibility in the eyes of other policy actors as well as the public, requires unquestioned political neutrality, demonstrated technical expertise - and a good measure of diplomacy!
Whether that counsel is provided in public or in private is a matter where opinions differ. To my mind, two things are clear. If the analysis and advice have a bearing on the current or future interest rate settings that will be required to maintain price stability, transparency is demanded. If not, and publicity around the advice-giving would hamper continued access to those who are responsible, it should be private.
I have argued that the improved governance of monetary policy in Mexico has been a process that has involved sustained effort over many years. The remarkable successes in recent years justify confidence that the arrangements now in place should keep inflation low in the future.
But a wise central banker should always be alert to the risks. So let me finish by noting a couple of them. One domestic risk is that new generations of decision-makers could take relatively well anchored expectations of inflation for granted. The recent judgment of Agustín Carstens and Luis Jácome that the earlier strong support that Latin American governments had given to firm anti-inflation policies has been losing momentum is frankly worrying.1Taking credibility for granted has been probably a particular risk in countries where other institutions of public administration are comparatively weak.
There are also significant international risks in the current global economic and financial climate. In an uncomfortable number of dimensions, the world economy has been living with a configuration of financial prices and financial balances that is simply not sustainable. Strong global demand and an extraordinary rise in oil prices have led to rates of headline inflation in several major countries that are higher than seen for many years. In this situation, it is not difficult to paint a rather bleak picture - higher inflation, the increased threat to growth from higher energy prices, and the risk of sudden declines in asset prices, with all the usual risks of financial market volatility.
As Mexico discovered in 1994, and several other countries in later crises, adjustment to significant disequilibria can involve very high costs that overwhelm the ability of policymakers to respond. The key to avoiding this is to analyse carefully the exposures that such risks create and to be sure that policy arrangements can cope with adverse circumstances. As you know, the Bank of Mexico and other central banks devote a good deal of time to analysing such risks in BIS committees. The reduction of external debt, the development of local currency bond markets, and the genuinely flexible exchange rate regime mean that Mexico is much less exposed to external crises than in 1994. And the governance arrangements that are now in place, supplemented by the discipline and transparency of the inflation targeting framework, provide the foundations for the Bank of Mexico to reach its 90th birthday, having weathered the difficult times that may well lie ahead.