Inflation Targeting in Brazil, Chile, and Mexico: Performance, Credibility, and the Exchange Rate

Inflation targeting is the new kid on the block of monetary regimes. Since New Zealand first adopted the regime in 1990, a growing number of industrial and developing countries have followed suit. To date, nineteen countries have anchored their monetary policy to explicit quantitative inflation goals. Even the Federal Reserve has suggested introducing inflation targeting in the United States, and academics have urged the Bank of Japan to adopt inflation targeting in an effort to jumpstart the Japanese economy. ¹ The European Central Bank has adopted a two-pillar system based on both inflation and monetary targets, but many observers argue that in practice it is very close to a pure inflation targeting regime.

Latin America is part of this world trend. After recording the highest inflation in the world in the 1980s, the region implemented a substantial departure from past policies starting in 1990. The results have been dramatic. In the 1980s four countries recorded average inflation rates above 200 percent a year, and the average regional inflation rate stood at 145 percent. In contrast, most Latin American economies currently maintain low, single-digit inflation rates close to industrial-country levels. Price stabilization has been achieved in the region under different monetary and exchange regimes, ranging from exchange-rate-based stabilization and dollarization to inflation targeting in combination with floating exchange rates. In fact, Latin America's recent experience strongly confirms the two-corner hypothesis regarding the choice of monetary and exchange rate regimes. ² Most countries are strengthening their national currencies by adopting inflation targeting combined with a float, while some economies are giving up monetary policy and national currencies by evolving toward dollarization. Even currency boards seem to be part of the broad range of intermediate arrangements that are on their way out, as suggested by the current crisis in Argentina.

Inflation targeting has been adopted by Chile (in 1990), Peru (1994), Mexico (1999), Brazil (1999), and Colombia (1999). In all cases, the monetary authority implemented inflation targeting when inflation rates were well above long-term stationary levels, applying the regime to allow for less costly convergence toward low stationary inflation. Moreover, four of the five Latin American cases pursued an evolutionary approach in adopting inflation targeting, only gradually putting in place the bells and whistles of a formal inflation targeting framework. The exception was Brazil, which adopted inflation targeting with a revolutionary big-bang, establishing most inflation targeting features from the very beginning.

Does the adoption of inflation targeting make a difference? Inflation targeting countries have certainly reduced their inflation levels, but careful evidence provides a more cautious picture. Bernanke and others show that the adoption of inflation targeting did not make a difference in the cost or speed of price stabilization. ³ Cecchetti and Ehrmann present evidence that, on average, inflation targeting countries exhibit degrees of inflation aversion that are no higher than those of nontargeters. ⁴ Mishkin and Schmidt-Hebbel indicate that countries under inflation targeting exhibit some structural differences with countries under alternative monetary frameworks. ⁵ Corbo, Landerretche, and Schmidt-Hebbel, who empirically evaluate ten years of inflation targeting experience in the world, arrive at the more positive conclusion that inflation targeting has succeeded in reducing output costs of stabilization and strengthening policy credibility. ⁶ Finally, Corbo and Schmidt-Hebbel compare inflation targeting in five Latin American countries to other inflation targeting experiences in the world. ⁷

Various questions on inflation targeting experiences in Latin America have yet to be addressed. For example, how does the performance record of monetary policy under inflation targeting in these countries compare with a control group of other inflation targeting experiences? Four important issues arise regarding the possible contribution of inflation targeting to strengthening credibility. Do inflation targets influence inflation expectations? Do inflation targets affect inflation? Has inflation targeting helped reduce the effect of volatile inflation on...