From the 1990s onwards Latin American countries began to rein in the pervasive inflationary dynamics that had done such harm to their economic development for so long. The mechanisms by which this shift was achieved were similar: fiscal prudence and de facto independence for the central bank, which was given an unequivocal mandate to control inflation. With the move to flexible exchange rates, inflation-targeting regimes were introduced to anchor inflationary expectations. Generally, although central banks allowed exchange-rate flexibility in the medium term, the monetary authorities adopted a policy of loose foreign-reserve management aimed at smoothing out any potentially disruptive short-term capital flows or current-account swings which could in turn trigger a liquidity crisis.
Upward pressure on exchange rates during 2007-08 led to central banks accumulating significant reserves – reserves that were to prove useful, in combatting the global liquidity shortage after September 2008. Stability in external balances, coupled with a flexible-exchange rate policy, then allowed many countries to adopt a successful expansionary monetary-policy stance during 2009.
The success of monetary policy can be seen in the reductions in interest rates during 2009 – reductions that were not accompanied by a rise in inflationary expectations (Figures 0.11 and 0.12). Control of inflation (and credibility over inflationary expectations) meant that real wages did not collapse, as they generally had done in previous Latin American crises.
As with aggregate economic performance, it is still too soon to quantify how much of this monetary success was due to internal or external factors. On the one hand is the region’s hard-earned central-bank credibility and on the other improving external conditions, including the increased liquidity in OECD countries which led to low interest rates around the world. Differences in the responses of different Latin American economies are certainly suggestive that acquired domestic credibility, if not the only factor, did contribute in no small measure to the effectiveness of monetary policy. Furthermore, monetary policy – measured as control of inflation, reserve accumulation and exchange-rate flexibility; – remained mostly intact by the end of 2009, despite the pressure on reserves from their active use to counteract episodes of liquidity scarcity.