Central banks in Latin America and the Caribbean have undoubtedly been part of the solution to our current crisis. Their prompt and effective reactions were made possible by the hard-won credibility that they gained in recent years. Behind those gains is the autonomy delegated to them to formulate and implement monetary policy to achieve their primary objective of maintaining price stability, and, in several cases, the additional goal of preserving financial stability.
Central banks rose to the unprecedented challenges of the Covid-19 crisis, aggressively injecting liquidity into their economies and keeping inflation rates under control. These policies can be sustained only if central banks are perceived as autonomous and there is confidence that they will defend their objectives. Political independence leading to higher central bank autonomy is associated with lower inflation rates and financial stability.
Trying to take away central banks’ autonomy or force them to assume other goals is not a sensible path. Both price and financial stability are key goals that central banks need to fully focus on. These objectives help to avoid losses in purchasing power and to make better consumption and investment decisions, contributing to economic stability and protecting mainly lower-income households and businesses. Including other objectives, such as competitiveness or employment, that are best accomplished through other policies and are hard to measure in terms of effectiveness, could lead to inconsistencies and dent credibility in relation to attaining the primary goals. Rather, we need to continuously strengthen central bank accountability, transparency, and corporate governance.
This time around, given relatively strong monetary frameworks, including well-anchored inflation and inflation expectations, central banks reduced interest rates and reserve requirements and bought assets and issued liabilities expanding their balance sheets. That expansion in Brazil, Chile, and Peru amounted to more than 10% of GDP—a huge effort and close to that seen in some advanced economies. As a result, the demand for greater liquidity was accommodated and credit actually rose in most economies in the region.
Central Banks operate under legal frameworks, which differ among countries in the region. To a large degree, it was these constraints that explain the pattern and composition of the liquidity injections across countries, with some central banks providing more liquidity to banks and others to governments.
The legal constraints exist for good reasons. In the 1980s, some central banks massively expanded base money (one part of central bank liabilities) to finance fiscal spending and to contribute to bailouts of financial sectors after serious banking crises. That led to high and persistent inflation. Given the costly but eventually successful reforms in the 1990s and 2000s, central banks in most countries have managed to maintain low and stable inflation rates in recent years.
Given recent actions by central banks, it is natural to worry that there could be a repeat of those dark days. There are several possible scenarios, and the manner in which the health crisis unfolds could push things one way or another.
One possibility is that vaccination rates rise swiftly and countries continue to open up so that economies recover, lost jobs are regained and household spending resumes to close to pre-crisis levels. But there may still be supply constraints for some goods, and that could push prices up. This has already happened in some countries. This poses a dilemma for central banks. If the price increases are temporary, there could be an increase in the inflation rate, most likely short-lived. But there is also the danger that inflation expectations may become de-anchored. The central banks in Brazil, Chile, and Mexico have already increased the policy interest rate to contain this potential threat.
Again, maintaining central bank autonomy is critical. Curiously, central banks generally have to do less, the greater is their credibility and their reputation for independence. For highly credible central banks, simply stating what their objectives are and what they would do if they have to may be enough to realize the targets without any actual action. But if there is doubt about that independence, central banks may have to raise policy interest rates more to contain inflation and that could hurt economic recovery.
There are other and perhaps more serious scenarios. If the health crisis continues due to slow vaccination rates, and new and more contagious and dangerous mutations emerge, economic recovery could be further delayed. In that case, there could be a need to continue exceptional fiscal spending just as international interest rates begin to rise and access to financing becomes more expensive or even dries up. Under those circumstances, central banks may come under pressure to come up with creative ways to finance fiscal spending. Their charters and autonomy could then come under threat. Persistent monetary financing could undermine the reforms of recent years and generate the conditions for higher and more persistent inflation. A short-term goal of financing additional spending might be accompanied by longer-lasting and costly consequences for economic stability going forward. In recent years, the region’s central banks have become more independent and transparent, and the communication of policy decisions has improved. The result has been low and stable inflation and stable financial systems. Those are hard-won and valuable achievements, and after the valiant efforts to fight the effects of the pandemic, they should be protected. Central bank autonomy should be seen as a key priority to allow for an inclusive and sustainable economic recovery.