Most of the economies which have autonomous Central Banks , might count on it as a key tool for price stability .Latin America in the nineties started off with its own experience on the matter ,and the outcomes so far are pretty satisfactory. On average, Inflation rate has been steadily going down , up to a one digit level , something quite unusual a few years ago. Between 1972 and 1987 the average rate of inflation in six countries (Brazil 166% , Peru 2789%, Chile 802%, Bolivia 602% , Mexico 3710% and Argentina 257% ), was 150% on a year by year basis !.
On the other side, while in the year 2010 the average inflation rate in Latin America was 6,6% , during the year 2011 it is expected to be 7,7%. The inflation rate for this year, is going to be a main concern for Latin America Central Banks. The path of strong economic growth ,and the risk of inflationary pressures which comes along with it, becomes the issue to deal with it.
In this case the usual (textbook) approach, is for Central Bank to increase interest rate. Another matter is the speed and the magnitude of such increases, which depends on each economy particular situation. The fact is that before the global Financial crisis (2008), this kind of decisions was based on inflation gap ( The difference between the spot and the long run target inflation rate), without any consideration (aside from the output gap),other than to get inflation back on track.
The financial events of 2008, made clear that Central Banks must also include within its policy options the financial sector exposure to systemic risk. As interest rate goes up, Banks begins to feel the impact on its loans performance. The probability of default rate might increase. At the extreme (2008), it might get the whole financial system with it.
The contractive nature of increases in interest rates, impose an additional restriction. After all, as the economy cool itself down , the inflationary pressures also goes down calling for slowing the pace of interest rate increases .Besides , all of these chain of events works with lags, therefore in the mean time the issue of credit access to overcome the slower demand, with higher expected default rate, become critical. Thus, the financial sector enter into the optimization rule twice :
a.- Its risk exposure, which might be a threat to the whole financial system as the interest rate goes up.-
b.- Its flexibility to work counter cyclically, to financing the cash flow when firms needed it most, mainly those labor intensive medium size firms.
It might be the case that when condition (a) and (b) are so to speak, less than 0(high risk exposure and low flexibility to finance cash flow), Central Banks might turn out to impose unexpected efficiency loses on its effort to get inflation under control. The Chilean experience in 1998 and 2009,suggest that the Central Bank approach ,misses out the integration of key financial variables into the macro policy decision model. In both cases, the Chilean economy got a mild recession (-1,5%) following a previous steady pace of economic growth.
