Today, we are pleased to present a guest contribution by Steven Kamin (AEI), former Director of the Division of International Finance at the Federal Reserve Board. The views presented represent those of the authors, and not those of the institutions with which the authors are affiliated.
Responding to the rise in inflation that followed the pandemic recession in 2020, central banks in Latin America responded more aggressively than authorities in other regions, as can be seen in Figure 1 below.
Figure 1: Changes in Policy Interest Rates Since December 2020
The relative prudence of Latin American central banks also appears conditional on inflation, as shown in Figure 2. The horizontal axis shows how much core inflation (excluding food and energy) has risen in each country since December 2020, just before inflation started to rise globally. The vertical axis measures each country’s increase in policy interest rates over that period. Clearly, as shown by the blue downward line, countries that experienced a large increase in inflation raised the policy interest rate more. Latin American central banks lie near or above the shaded region (representing a 68% confidence interval).
Figure 2: Increase in inflation and policy rates from December 2020 to August 2023
My colleagues Rafael Guerra, John Kearns, Christian Upper, Aatman Vakil, and I wanted to know whether Latin American central banks have been aggressive in their response to inflation, or whether they have become hawkish in recent years . We began by estimating the regression of the Taylor Rule panel on the policy measures of the five major inflation-targeting banks—Brazil, Chile, Colombia, Mexico, and Peru—in the pre-pandemic period. Column 1 (which includes the real exchange rate—insignificant) and column 2 (not showing) show that in the pre-pandemic period, both inflation and the output gap affected policy rates, with coefficients of significant size. But column 3, which extends the estimate until 2023 and includes blind variables for the period after 2019, shows that the inflation coefficient has increased significantly and the coefficient of the fixed policy rate has decreased, indicating an acceleration of the interest rate.
In addition, as shown in Figure 3 below, pre-pandemic projections estimating the Taylor Rule during the pandemic showed that most Latin American central banks tightened policy more (red line) than predicted by the pre-pandemic model (blue line). This suggests, again, that Latin American central banks have become more hawkish on monetary policy after 2019.
Figure 3. Simulation of Linear Taylor Estimated Models 2007-2019, based on Tables 1 and 2, Column 2
However, we are not convinced that the reactionary activities of Latin American central banks had really changed. Instead, we hypothesized that Latin American monetary policy is likely to show an indirect response to inflation, with the sensitivity of interest rates rising as inflation becomes more pronounced. Such behavior may reflect concerns that as inflation rises, the greater the likelihood that inflation expectations will be misaligned, and therefore the greater the need to defer inflation.
So we re-estimated the Taylor law model described above, but added the interaction terms with inflation, as shown in Table 2. The coefficient of the inflation rate is now insignificant, while the coefficient on its square is positive and significantly different from zero. This setting shows that during the pre-pandemic period, the sensitivity of interest rates on cash flow increased significantly as inflation itself increased. In other words, interest rates showed an indirect response to inflation.
In column 3, we extend the estimation until 2023 and include interaction terms with the epidemic dummy. The coefficients on both the output gap and the square of inflation are unchanged over the period 2021–23 from their values in the pre-pandemic period. This suggests that this indirect version of the model may better capture the behavior of monetary policy in both pre- and post-pandemic periods. Notably, the non-linear model still shows a significant decrease in the coefficient on the amount of delayed policy from the pre-pandemic period; this is worth exploring in further research.
Now we return to Figure 3 above. The green lines in Figure 3 compare the out-of-sample predictions of the non-linear model with the actual means of interest rates (red) and the predictions of the linear Taylor rule models (blue) described above. As can be seen, the non-linear models come very close to tracking the sharp rise in interest rates between 2022 and 2023 in Brazil, Chile, and Colombia.
Therefore, the aggressive monetary policy response to inflation in 2021–2023 appears to have been a smaller break from past behavior than would appear from a Taylor law perspective. That aggressive response was consistent with earlier responses by Latin American central banks to sharp increases in inflation. Our results are robust to different definitions of prices and outputs and to different economic specifications. We aim for future research to see if this conclusion holds for monetary policy in other parts of the world.
This post was written by Steven Kamin.
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