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The paper examines possible monetary policy strategies for Latin America that may help lock-in the gains in the fight against inflation attained by the region during the 1990s. Instead of focusing the debate about the conduct of monetary policy on whether the nominal exchange rate should be fixed or flexible, the focus should be on whether the monetary policy regime appropriately constrains discretion in monetary policymaking. This focus suggests that there are three basic frameworks that deserve serious discussion as possible, long-run strategies for monetary policy in Latin America: a hard exchange-rate peg, monetary targeting, and inflation targeting. We look at the advantages and disadvantages of each of these strategies in light of the recent track record of monetary policy in several Latin American countries for clues as to which of the three strategies might be best suited to economies in the region.

The monetary policy experience of Latin America has not been a happy one. Economies in this region have gone through extreme episodes of monetary instability, swinging from very high inflations, to massive capital flight, to collapses in their financial systems. The unsurprising outcome has been low credibility, slow growth, recurrent recessions and even depressions. However, a new era may be dawning in Latin America. In the past decade or so, most countries in the region have become outward looking, and the public, politicians and policymakers have come to recognize the high costs of protectionism and inflation, producing a growing commitment to open markets and price stability. Evidence of this more favorable environment are the successful inflation stabilization programs adopted by many Latin American countries in the early 1990s, and the historically low rates of inflation attained by the region in recent years, falling from an average of over 400% in 1989 to below 10% by 1999. Where should Latin American countries go from here in designing appropriate long-run strategies for the conduct of their monetary policy? The central issue in addressing this question is whether the countries of the region have a chance of setting up institutions and mechanisms that will effectively and efficiently constrain the discretion of their monetary authorities. Whether the exchange rate is fixed or flexible (and precisely how flexible) follows from the answer one gives to that question. Thus, we believe that there is a need to refocus the debate away form a discussion of whether the nominal exchange rate should be fixed or flexible. One advantage of the alternative approach that focuses on underlying institutions to appropriately constrain monetary policy discretion rather than on the flexibility of the exchange rate is that it allows one to draw on the experiences of countries outside Latin America to a larger extent than what is possible in the present round of the “Fix versus Flex” debate.1 In principle, there are four broad monetary policy strategies that can produce a nominal anchor that credibly constrains the discretion of the central bank over the medium term: “hard” exchange-rate pegs, “soft” exchange-rate pegs, monetary targeting, and inflation targeting.2 The severe shortcomings of soft pegs (in their multiple manifestations) as a medium-term strategy for monetary policy have been amply demonstrated by recent experiences in industrial and emerging market economies (including many from Latin America) and need not be repeated here. 3 This leaves us with three potential medium-term strategies for monetary policy that we evaluate in the following sections. In each section, we look at the advantages and disadvantages of each strategy, and then examine the recent experience of relevant Latin American countries for clues as to which of the three might be best suited for countries in the region.

We have taken the view that the real debate over monetary policy regimes in Latin America should not be over whether the exchange rate regime should be fixed or flexible. Instead, the debate should be over what is the best way to constrain discretion over monetary policy in Latin American countries. Like most economists, we come up with the answer that “it depends,” in particular, we think that the key to the answer lies on the institutional environment in each country. There are some countries in Latin America which do not appear to have the political and other institutions to constrain monetary policy if it is allowed some discretion. In these countries, there is a strong argument for hard pegs, including full dollarization, which allow little or no discretion to the monetary authorities. On the other hand, there are countries in Latin America that seem to have the ability to constrain discretion, with Chile being the clearest example, and for these cases, we believe that inflation targeting is likely to produce a monetary policy which keeps inflation low and yet appropriately copes with domestic and foreign shocks. Monetary targeting as a strategy for Latin America is not viable because of the likely instability of the relationship between monetary aggregates and inflation, of which there is ample international evidence. Therefore, it is not surprising that no Latin American country has truly followed a monetary targeting strategy, and those that have tried or have been regarded as trying, have instead conducted a highly discretionary monetary policy which is, of necessity, non-transparent and has the potential of breaking down at any point. Proponents of different strategies for the conduct of monetary policy often have a tendency to argue that their preferred strategy will be a panacea that will help resolve hard problems such as fiscal dominance. The experience in Latin America suggests that these arguments are quite problematic because a monetary policy strategy, no matter whether it involves a hard peg or an inflation target, will not be successful in maintaining low inflation over the medium term unless government policies create the right institutional environment. Rigorous prudential supervision, which ensures the safety and soundness of the financial system, is crucial to the success of an inflation targeting regime just as it is for hard pegs. Also, sound and sustainable fiscal policy is as essential to the success of inflation targeting regimes as it is to the viability of hard pegs. Large fiscal deficits and the ensuing buildup of government debt will eventually lead to the failure of both types of regime. The bottom line is that adopting a strategy for monetary policy, whether it be a hard peg or a regime with greater flexibility of exchange rates, like inflation targeting, cannot solve the basic problems that have existed in Latin American economies for a long time. Successful monetary policy in Latin America cannot be done in a vacuum. Design of the basic institutional infrastructure in those economies must be addressed and improved in order to attain and preserve low and stable inflation. A number of economists (e.g., Eichengreen and Hausmann, 1999) have become convinced that Latin America is subject to some type of “original sin” and thus is unlikely to grow up and develop institutions which would promote good monetary policy. With this view, it seems sensible to effectively close down central banks and adopt a currency board or to go for (unilateral) full dollarization. We are quite skeptical of the “original sin” argument. The recent successes in bringing down inflation in many countries of the region suggests to us that it is possible for Latin America to develop institutions which would allow its central banks to follow a monetary policy focused on keeping inflation low while preserving some scope to mitigate output fluctuations. We are thus not convinced that it is time to give up on the maturation of Latin America, and believe that the move towards inflation targeting that has started in the region will continue and make further inroads in the years ahead.