A couple of weeks ago I went to Colombia, and I found several things that were “business as usual”, but some others that were very unusual.
It was not surprising that the cab driver knew the exchange rate up to the third decimal. It was surprising that he spent half an hour talking about the impact of the real exchange rate appreciation and what should be the proper monetary policy response to capital inflows. He was fairly worried. It was expected that most people in the private sector were concerned with the strengthening of the peso and the excessive boom in the real estate market; as was predictable that they were complaining constantly. It was unexpected, however, that they put all the blame on the monetary authority and excused so rapidly the fiscal side from any responsibility. Hence, they mostly whined. Finally, it was not shocking that they were absolutely insulted by my policy advice; what was astounding is that I really didn’t mean to insult them this time. I only suggested that they should increase taxes. They were noticeably unwilling.
In this new world, in which inflation targeting is taking over every single possible piece of land with a flag, it is interesting to evaluate how much a central bank can do to control a severe exchange rate appreciation. First, it depends on what type of shock hits the economy. Monetary policy would find easy to handle a demand shock that creates both an appreciation of the exchange rate and domestic inflation, but it would have a hard time dealing with a supply shock that creates deflation and an appreciation of the real exchange rate. Second, it depends on the strength of the financial sector to handle large fluctuations of interest rates and the money base to be able to stabilize the real exchange rate. And finally, it depends on how coordinated the fiscal side is with the monetary authority. It is really difficult to control a real exchange rate appreciation driven by capital inflows when the fiscal side decides to embark in an expenditure extravaganza at the same time – you know, like Venezuela every time oil prices increase.
I believe that in inflation targeting regime the fiscal side has a larger share of the responsibility in the stabilization of the economy, and transitory real exchange rate appreciations, real estate market booms, or overheating in the labor market, have to be resolved with counter-cyclical fiscal policies more forcefully.
I would like to open a discussion on how Latin American countries, that are experiencing massive capital inflows and improvements in their terms of trade, but have moved their monetary policies toward inflation targeting regimes, can cope with the real exchange rate appreciation without the help of the fiscal side.