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Inflation Targeting in Peru: The Reasons for the Success

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Abstract

The Peruvian central bank took two major decisions in the early 2000s: implementing an inflation target system and accumulating sufficient foreign-exchange reserves. These two decisions have allowed the central bank to preserve macroeconomic stability in favorable or unfavorable international environments. The use and impact of the main monetary policy instruments over the period 2002–2013 is discussed, namely, the short-term interest rate set by the central bank or reference interest rate, the reserve requirement ratio in local and foreign currencies, and, finally, sterilized intervention in the foreign exchange market. The process of bank credit (de)dollarization is also reviewed.

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Notes

  1. The foreign exchange position discounts two items of the net international reserves (RIN) managed by the BCRP: external assets that belong to the government, and external assets (reserve requirements in foreign currency and others) that belong to the private banking system.

  2. On supply and demand shocks that explain the evolution of inflation during this period, see Lavanda and Rodríguez (2011).

  3. The reference interest rate was 4.25% per annum from May 2011 until October 2013. It decreased to 4% between November 2013 and June 2014. Oddly, the central bank announced that this was not the start of a sequence of reductions in the reference interest rate.

  4. The 1993 Political Constitution of Peru establishes that ‘the purpose of the Central Bank is to maintain monetary stability’. One of the functions of the Central Bank, according to the 1979 Constitution, was to ‘defend monetary stability’. Ensuring monetary stability has been politically compatible with the BCRP’s decision in 2002 to adopt the inflation targeting system. Given Peru’s traumatic experience with the hyperinflation of the late 1980s, it is clear that a flexible inflation targeting system, which pursues both price stability and full employment, would give primacy to the objective of maintaining low inflation if there were a conflict between both objectives.

  5. The IMF study (2014), which is based on Salas (2010), estimates a complete macroeconomic model (an aggregate demand curve, an aggregate supply curve, and an uncovered interest rate parity equation) for the Peruvian economy, in addition to this Taylor rule.

  6. To estimate the potential output, a Hoodrik-Prescott filter has been used.

  7. The lending interest rates that influence aggregate demand are long-term rates. The central bank controls a very short term interest rate (the typical interbank loan term is overnight). This implies, following the expectation theory of the term structure, that expected reference interest rates for the future are a key determinant in various lending interest rates, as well as the current reference interest rate. It also implies that the central bank usually changes the reference rate in cycles of increases and decreases so that the current and expected future reference rates move in the same direction (see Ball, 2012, Cap. 13).

  8. This includes the case of rationing in credit markets; if there is no rationing, the aggregate demand only depends on the interest rates (see Stiglitz and Greenwald, 2003, Cap. 6).

  9. The methodology utilized is that of Gambacorta (2001) or Worms (2001), which employ dynamic panel models to determine whether the reference interest rate influences the growth of bank loans in different European countries, controlled by the macroeconomic context and the specific characteristics of the banks (see Erhman et al. 2001). In Brazil, Takeda et al. (2005) simultaneously incorporate the interest rate and the reserve requirement ratio set by the monetary authority in a dynamic panel with monthly data over the period 1994–2001; the result is that only the reserve requirement ratio has a negative and significant impact on the growth of credit extended by banks.

  10. The period 2003–2011 encompasses two stages of recovery from recession (2003–2005 and 2009–2010), a boom (2006–2008) without precedent in the Peruvian economy, and a recession (2008–2009) caused by an adverse external shock when an expansive monetary policy was applied for the first time.

  11. Another option is to measure the impact that the reference rate or the reserve ratio have on the interest rate charged by individual commercial banks and cajas municipales throughout the period (see Gambacorta, 2004; Weth, 2002). No study of this kind has yet been conducted on the Peruvian economy. Existing studies estimate pass-through coefficients that connect the changes in the reference interest rate with the changes to average or aggregate bank lending or deposit interest rates, of differing terms and in local currency. As the BCRP (2009) documents, these coefficients have been on the increase over the last decade and are greater for short term interest rates.

  12. On assessing the effect that the reserve requirement ratio in local currency has on volumes loaned and the interest rates set by commercial banks and cajas municipales, Armas et al. (2014) do not control for the possible impact that the reference interest rate may have.

  13. The model of Bernanke and Blinder (1988) could be described as an IS-LM model with banks (see Dancourt, 2012a).

  14. According to García-Escribano (2010), the component of total credit that accounts for most de-dollarization is commercial credit for firms, especially manufacturing, trade, and real estate. Garcia-Escribano (2010) shows that ‘dollarization of loans with longer maturities (mortgages and commercial) is higher than loans with shorter maturities (consumer and small businesses)’.

  15. The introduction of these reserve requirements on foreign liabilities of commercial banks can be represented as a rise in the foreign interest rate, which implies a reduction in aggregate demand and economic activity. For a model in which local banks also lend in foreign currency, and where the rise in this reserve requirements on foreign liabilities increases the local lending rate in foreign currency (see Dancourt, 2012b). According to Armas et al. (2014), the BCRP’s macroeconomic model ‘assumes that changes in this instrument increase bank lending rates. The estimated impact of a one percent rise on the average RR (reserve requirement) rate is about 0.3% on the average lending rates denominated in domestic currency and 0.1% on lending rates denominated foreign currency’.

  16. The total (short and long term) external debt of the banking system figures are set out in table 7B of the BCRP’s Nota Semanal. The figure for the external debt of the banking system subject to reserve requirements is set out in Table 18 of the BCRP’s Nota Semanal. The external debt of the banking system that are NOT subject to reserve requirements is calculated by difference. The figures from Table 18 are daily averages for the month, and those of Table 7B are end of period data, but we have not been able to resolve this issue. For an analysis of the successive amendments to regulations on the foreign currency reserve requirements that characterize the third stage (see Dancourt and Jiménez, 2010).

  17. See Reporte de Inflación de diciembre de 2013, p. 101.

  18. Herrman and Mihaljek (2010) study ‘the determinants of cross-border banks flows to emerging markets in periods of crises’. They find that in the Asian crisis of 1997–1998 and in the 2008–2009 international crisis, ‘global risk factors (…) made the largest contribution to the reduction in cross-border bank flows’.

  19. The 12-month growth rate of credit in foreign currency fell from 26% in July 1998 to −4% in July 1999; from 30% in October, 2008% to −1% in October 2009; and from 18% in November 2012 to 2% in March 2014.

  20. García-Escribano (2010) does not utilize the external debt of the banking system as an additional variable that contributes to explaining the (de)dollarization of banking credit.

  21. See the detailed description of the use of this instrument in Rossini et al. (2013).

  22. See Williamson (2013), Cap 10, on commodity export price volatility and long term economic growth.

  23. On the exchange rate pass-through coefficient, see Reporte de Inflación (2013, setiembre) p. 119, Maertens et al. (2012), and IMF (2014).

  24. A leading actor in the speculative attacks associated with the external crises of 2008 and 2013 has been private pension funds (AFPs) that manage a financial asset portfolio, without regulatory limits by currency, of a magnitude only comparable to the central bank’s foreign exchange position. For example, in the Presentación del Reporte de Inflación de diciembre de 2013, Slide 41, it is reported that the highest local demand for dollars between May and November 2013 was generated by AFPs. From 2006 to mid-2014, the percentage of this financial portfolio invested in foreign assets increased from below 10% to close to 40%; the operating limit on AFPs’ foreign investments is set by the central bank.

  25. See the work by Costa and Rojas (2002) that analyses the banking crisis of 1998–2000. Espino (2013) shows the basic stylized facts of the banking system, which include this link between non-performing loans and the exchange rate. Herrmann and Mihaljek (2010) find that a rise in the exchange rate causes reductions in external debt flows to commercial banks in emerging market economies.

  26. For the 1998–2000 recession and the tight monetary policy that was applied, see Mendoza (2013).

  27. According to Tobin (1999), a combination of fiscal policy (greater public spending that reactivates the economy) and monetary policy (higher interest rate that causes an appreciation in local currency) could also maintain price stability and full employment, despite the adverse external shock. With a small government and without automatic fiscal stabilizers, as in Peru, it is doubtful that the combined recessionary effect of the adverse external shock and a restrictive monetary policy could be counteracted in time by an expansive fiscal policy. It is also doubtful that a practicable rise in the local interest rate could prevent the exchange rate from going up if the price of gold and copper fall, or if Bernanke announces that the Fed will reduce its long term bond purchases.

  28. Also an expansionary fiscal policy was applied (see Rossini et al., 2013; Mendoza, 2013).

  29. The real exchange rate is reduced by one third between the peak of September 2002 and the floor of January 2013; the bulk (70%) of the fall of the real change happens from 2007.

  30. If the monetary authority takes the decision to reduce the inflation target in an economy like Peru, the central bank should raise the reference interest rate or sell foreign currency (see Dancourt, 2012b).

  31. In the period 1992–2001, foreign currency sales were scarce, even in the 1998–2000 crisis phase, because there were not enough foreign exchange reserves (foreign exchange position). Purchases of dollars occur, mainly, when the exchange rate increases.

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Dancourt, O. Inflation Targeting in Peru: The Reasons for the Success. Comp Econ Stud 57, 511–538 (2015). https://doi.org/10.1057/ces.2015.5

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