Inflation Targeting and Quantitative Tightening: Effects of Reserve Requirements in Peru

As a policy response to address the macroeconomic challenges brought about by financial dollarization and the resulting vulnerability of the financial system, the Central Bank of Peru adopted an inflation-targeting regime in 2002, becoming the first policy authority to implement this framework under a dual monetary system. The inflation-targeting regime in Peru has a particular design. The central bank actively intervenes in the foreign exchange market to smooth exchange rate fluctuations and to build international reserves as a self-insurance mechanism against negative external shocks. Moreover, reserve requirement policy is used as an active monetary control tool to tame the impact of capital flows on domestic credit conditions denominated in both domestic currency (the nuevo sol) and foreign currency (primarily U.S. dollars). The central bank has also set high reserve requirements on foreign currency liabilities as a prudential tool to mitigate liquidity and foreign currency credit risk. These additional policy tools have relaxed the trade-offs that the central bank faces when implementing standard monetary policy within an inflation-targeting regime that simultaneously takes into account financial stability considerations. Moreover, the ready use of reserve requirements in the Peruvian monetary policy framework has allowed the central bank to induce the necessary quantitative tightening required to face the domestic spillover effects of the unprecedented quantitative easing policies engaged in by developed countries.

Based on this experience, this paper evaluates the relevance of reserve requirements as a complementary instrument for monetary policy. To this end, we provide a detailed account of the rationality of its use in Peru, explore how changes in reserve requirements policy propagate and affect credit conditions, and make a quantitative assessment of its impact on monetary and credit conditions using a counterfactual policy analysis.

The paper is organized as follows: The next section provides an overview of the Peruvian monetary framework, including the standard interest rate setting. The paper then discusses the use of reserve requirements as a monetary policy tool, the transmission mechanism of reserve requirement changes, and the control of financial dollarization risks and liquidity risks. We present our empirical evaluation of reserve requirement policies, and the final section concludes.

The Monetary Policy Framework

The current monetary policy framework in Peru has been in place since 2002. It is best characterized as a full-fledged inflation-targeting regime that takes explicit account of the risks brought about by financial dollarization. The target is a 2 percent annual increase in the consumer price index with a tolerance band that ranges from 1 to 3 percent. Before inflation targeting was adopted, monetary policy in Peru was implemented by a monetary target framework that used the annual money base growth rate as an intermediate target while also including instruments such as foreign exchange intervention and high reserve requirements for foreign currency deposits.¹

When the central bank adopted inflation targeting, the aforementioned policy tools used to confront the risks of financial dollarization were still in place. Several papers assess the implementation of the inflation-targeting framework in a financially vulnerable economy as a combination of a standard interest rate rule and the active use of other instruments to control financial risks.² Figure 1 illustrates the inflation-targeting framework set up in Peru.

Figure 1.

Inflation Targeting plus Dollarization Risk Control Framework in Peru

Source: Armas and Grippa (2005).

Since 2008, reserve requirements have been changed frequently to complement policy rate changes. The main reason for this new role for reserve requirements was the launching of the unprecedented expansionary monetary policies in developed economies, which triggered the zero lower bound for their policy interest rates and the implementation of quantitative easing. Emerging economy central banks had to respond with different actions to deal with the spillover effects of these ultra-easy policies, manifested in capital inflows and low international interest rates. Figure 2 summarizes the different economic cycles and policy responses of both developed and emerging economies during the quantitative easing period.

Starting in 2008, changes in the marginal and average...