– He headed the Central Bank between 2002 and 2005. Average annual inflation in 2002 was 14%. By 2005 it had fallen to 4.7%. How was this process? How was it achieved?
– The answer is somewhat simple: currency control. This, in turn, was made possible by an institutional framework that gave the BCU operational autonomy in managing monetary policy. The 1995 charter had limited the BCU’s ability to fund central government.
In reality, the 2002 burst of inflation was concentrated in the second and third quarters and followed the devaluation in June this year caused by Uruguay’s balance of payments crisis. After that crisis was resolved by a financial system cleanup that made it possible to halt the bank run and the 2003 debt swap that solved public sector funding problems, the way was paved for the BCU to get through monetary policy, relieving exchange rate pressures. In fact, inflation fell very quickly in the fourth quarter of 2002, stabilized in 2003 and continued on another sharp downward trend in 2004 to reach the 2005 levels.
– What role did the introduction of an inflation targeting system play in stabilizing inflation at a single-digit level?
– The inflation-targeting regime enabled this second drop in inflation between 2004 and 2005. While there was still uncertainty about the end of the financial and sovereign debt crisis, the BCU, whose credibility was severely punished, confined itself in 2003 to strictly targeting inflation to meet the monetary growth target, which basically allowed inflation to stabilize at around 11%.
With the financial and fiscal problems resolved, the BCU gained more room to maneuver to risk meeting a more ambitious inflation target in 2004.
This Uruguayan experience shows the importance of a central bank’s operational autonomy in committing itself to an inflation targeting system and that this is nothing more than an expression of desire.
– Inflation has just returned within target. Is it too early to cut interest rates?
– Not only the level counts, but also the direction and speed. If the BCU sees that inflation is falling very quickly and sharply, it can assume that there are other factors contributing to the fall in inflation and that some monetary easing is then warranted.
But there is a lot of “art” in this finishing touch. A central bank must always be aware of these movements in the markets and react immediately.
Before taking a step towards more accommodative monetary policy, one must be satisfied that the backbone of inflation is broken. This is what happens in a country like Uruguay when this perception is transferred to the labor market.
– Why was Uruguay able to avoid hyperinflation like Argentina?
– The difference is essentially institutional. Before the 1995 Charter was passed, currency crises always led to long periods of rising inflation. In some of them it even reached three-digit values. This has not happened since the BCU’s ability to fund the government through monetary expansion was limited in 1995.
Argentina built a good institutional concept for central bank autonomy in 1991, but set it on fire in 2001. The differences in inflationary behavior may be one of the expressions of the greater commitment Uruguay is showing to preserving previous institutional frameworks, crisis management and in any case progressive change.