CURRENCY-MONETARY POLITICS

Monetary policy
and the CYCLE

PAUL CASTLE*
ECONOMIC
In this article, the author explains how central

banks in emerging economies respond to the

business cycle, and under what conditions

countercyclical policies are effective.

* BCRP Monetary Policy Manager

paul.castillo@bcrp.gob.pe

CURRENCYNo. 179
The main objective of most central banks is with inflation targets can effectively
to maintain a low inflation rate, typically implement countercyclical monetary
close to 2 percent. This is supported by policies. Maintaining a low and stable
international empirical evidence that shows inflation rate is not in conflict with the
that in the long run the main contribution objective of stabilizing the business cycle.
of monetary policyto society is to maintain This is possible when fluctuations in
price stability. economic activity reflect changes in
Does this mean that central banks with aggregate demand that generate
inflation targets do not implement movements in the same direction in the
countercyclical monetary policies, product and in inflation. This situation is
understood as those that seek to stabilize what Jordi Galí has called a divine
coincidence. This is because when inflation
the economic cycle? This article briefly
discusses under what conditions central is generated by demand pressures, central
banks in emerging economies banks can simultaneously stabilize inflation
and economic activity.
GRAPHIC1
percentage)

8.0

6.0

4.0

2.0

0.0

Brazil Mexico FED

GRAPHICtwo
percentage)

brothers
2004Q4

2008Q4

2013T2
2011Q1
2011Q2
2011Q3

2012Q1

2013Q1

2017Q1
2005T2
2005T3

2006T2

2009T2

2012Q2
2012Q3

2017Q2
2017Q3
2005T1

2011Q4

2014Q1

2015Q1

2016Q1

2018Q1

2019Q1
2007Q1

2010Q2

2012Q4

2013Q3
2013Q4

2014Q2
2014Q3

2015Q2
2015Q3
2015Q4

2016Q2
2016Q3
2016Q4

2017Q4

2018Q2
2018Q3
2003Q3

2007Q3
2007Q4

2010Q1
2004Q1

2006Q1

2008Q1

2009Q1

2010Q3
2010Q4

2014Q4

2018Q4
2003Q4

2004Q2
2004Q3

2006Q3

2008Q2
2008Q3

2009Q3
2007T2
2005Q4

2006Q4

2009Q4

Output gap (in % of potential output)*

*BCRP

SEPTEMBER20195
CURRENCY-MONETARY POLITICS

GRAPHIC3
percentage)

7.0

6.0

5.0

4.0

3.0

2.0
1.75

0.0
Apr-13

Dec-14

Aug-16

Apr-18
Sep-13

Sep-18
Jul-14

Jan-17

Jun-17

Jul-19
Nov-12

Mar-16

Nov-17
Feb-14

May-15

Oct-15

Feb-19
* WITH INFLATION EXPECTATIONS.

economy by appropriately modifying

the short-term interest rate.
Central banks in the region have faced
The majority
this situation in several episodes since
2005. During the global financial crisis, of central banks
both inflation and growth slowed rapidly in has as purpose
2009, prompting an aggressive response
from central banks, cutting their policy
main maintain a
rates monetary. This was intended to low inflation rate,
stimulate economic activity, as well as typically close
reduce the risk that inflation would fall to 2 percent.
below their respective target ranges.
In the case of Peru, the BCRP reduced its

interest rate to its historical minimum, 1.25

percent, which was reflected in interest rates in
the financial system below their historical averages, environment of weak growth of aggregate
encouraging aggregate spending andcredit. to the demand, allows inflation to be within the target
private sector (see Chart 1). range and also contributes to stimulating
Consistent with the monetary policy response, the economic activity.
output gap, an indicator of inflationary demand However, there are circumstances in
pressures, and the BCRP's monetary policy rate, which divine coincidence is not observed,
show a positive correlation (see Chart 2). and central banks face a dilemma between
A countercyclical response by the BCRP was stabilizing inflation or economic activity.
also observed in the face of the negative This occurs when the shocks affecting the
impact of coastal El Niño on aggregate economy are supply shocks. These shocks
demand in 2017, which reduced the level of simultaneously generate more inflation and
aggregate spending below the level of lower growth. Shocks with these
potential output. Faced with this, the BCRP characteristics are persistent increases in
reduced its monetary policy rate from 4.25 the price of oil, capital outflows or falls in
percent in April 2017 to 2.75 percent in March the terms of trade, which generate
2018, with the aim of reducing the probability persistent depreciation of the domestic
that inflation will be located in the lower currency and deteriorate credit conditions.
section of the target range. With this level for In these circumstances, a reduction in the
the monetary policy interest rate, the real monetary policy interest rate could
interest rate is 0.25 percent, one of the lowest validate transitory increases in inflation,
interest rates since the beginning of this and thus generate an increase in
century (see Chart 3) and which is below the persistent inflation expectations.
level for the real interest rate that is Recently, several academic articles Bank for
considered neutral, estimated at 1.75 percent, International Settlements (BIS) have highlighted the
which clearly denotes an expansive monetary role that foreign exchange intervention and the
policy position. preventive accumulation of reserves can play,
as complementary instruments to the
monetary policy rate, to make this more
flexibletrade-off faced by central banks in the
face of external shocks.
Foreign exchange intervention and the use of
international reserves against capital outflows
reduce the effect of the depreciation of the
domestic currency on inflation, and at the same
time limit the negative impact of capital outflows on
domestic credit conditions, which can be seen
affected by drops in bank liquidity, or by a greater
solvency risk, if there are currency mismatches in
their clients.
In order to be able to use international
reserves effectively with the aim of supporting
countercyclical policies, they must be
accumulated preventively in such a way that an
adequate volume of them is available when
capital flows are reversed. Within what the BIS
has called the integrated approach to monetary
policy, the preventive accumulation of
international reserves against capital inflows is a
fundamental instrument, not only because it
allows for sufficient international liquidity to
reduce the impact of future capital outflows, but
also because the foreign exchange
intervention limits the expansion of credit in
been essential to be able to effectively
implement a countercyclical response, not
only in the face of the international
financial crisis, but also in the face of the
capital outflows generated by the process
of reversal of the monetary stimulus of the
US Federal Reserve. This allowed that the
BCRP maintained one of the lowest
interest rates during the period of the
global financial crisis (see Chart 1). As
shown in Graph 4, in the face of a negative
external shock, in which aggregate demand
is reduced, as well as aggregate supply,
associated with the lower capacity of banks
to give loans, the reduction in theinterest
rate and the sale of foreign currency by
the BCRP are complementary. The first
instrument aims to stimulate aggregate
demand, while the second,
In conclusion, a monetary policy aimed at
keeping inflation low and using additional
instruments, such as the preventive
accumulation of reserves, foreign exchange
intervention and the cyclical use of reserve
requirements, can not only achieve a more efficient
implementation of monetary policy,

the domestic financial system, (Shin 2019) two. but also a countercyclical response both tonegative
In the case of Peru, the policy of preventive aggregate demand shocks and to negative external
accumulation of international reserves has shocks.

GRAPHIC4
percentage)

п ΔS' ΔS
rate reduction

ΔD aggregate demand

on inflation and deflation

credit

1
Gabaix, X and M. Maggiori, 2015, “International Liquidity and Exchange Rate Dynamics”, The Quarter Journal of Economics, 1369-1420; Chang, R, L Cespedes and A Velasco, 2017,
“Financial Intermediation, Exchange Rates, and Unconventional Policies in an Open Economy”, Journal of International Economics, Volume 108, Supplement 1, May 2017, Pages S76-
S86; and Canzoneri, M. and R. Cumby, (2014), “Optimal Foreign Exchange Intervention in an Inflation Targeting Regime: Some Cautionary Tales,” Open Economies Review, 45,
two
429-450. Shin Hyun and Boris Hofmann and Mauricio Villamizar-Villegas (2019), “FX intervention and domestic credit: Evidence from high-frequency micro data”: BIS Working Papers
No 774.