XXVII Meeting of the Latin American Network of Central Banks and
Finance Ministers
Creeping Inflation: How much of a
concern? What should the Response
be?
Paul Castillo
Central Reserve Bank of Peru
InterAmerican Development Bank ,Washington DC,
May 2008
Outline
• Where is inflation comming from?
• Should central Banks respond?
• How the Central Bank of Peru is responding?
• Final remarks
Where is inflation coming from?
Where is inflation coming from?
• In most countries inflation is coming from high
food prices, triggered by the the sharp increase in
commodities prices, such us oil, corn, wheat, and
rice.
• Changes in food prices seem to reflect a
permanent relative price realigments.
• Increasing demand from China and other fastgrowing economies in Asia is an important factor
behind the boom in commodity prices.
Should Central Banks Respond?
• According to the literature, when inflation is
generated by changes in relative prices of goods
whose prices are not too sticky, like food, central
banks should not respond, Aoki (2001).
• In this case, the welfare cost of relative price
realigments is relatively small but the cost of
stabilization policy is much larger.
• Therefore, central banks do better focusing on
inflation of those goods whose prices are more
sticky, like core inflation excluding food and
energy.
Should Central Banks Respond?
• No response at all, however, could trigger higher
inflation expectations, particularly when there
exist imperfect knowledge about the source of the
shock.
• Sargent et. at (2003) show how uncertainty on the
costs of stabilizing inflation can lead to higher
inflation if this type of uncertainty delays the
response of the central bank.
• The high inflation period of the 70’s is illustrative
to this respect.
Should Central Banks Respond?
• In the 70’s the FED did not increased the interest
rate strongly enough to keep inflation expectations
anchored,
• Inflation expectations deviated and inflation
increased above 15 %,
• Then, a more restrictive monetary policy was
requiered to put inflation back on track.
• This policy was finally put in place by the
administration of Paul Volcker.
Should Central Banks Respond?
• On the other hand, a strong response to higher
food prices doesn´t seems a good idea either,
• It implies a costly adjustment in terms of output to
induce a deflation on the other prices of the CPI.
What to do then?
• The answer seems to be on a middle point,
• Increase interest rates to prevent deviations on
inflation expectations,
• But not too much that could damage output
growth rates and employment creation.
Central Banks have moved interest rates
considering these two factors
What to do then?
• Some of then, such as Bank of Canada, for
instance, cut interest rates considering that the
Subprime crisis in U.S.A, could damage output
growth.
• Others, like the Central Bank of Peru have raised
interest rates considering that inflationary riks were
higher and that the impact of subprime crisis on the
Peruvian economy was not going to be to large.
How the Central Bank of Peru is responding?
In Peru, as in most countries inflation is
explained by imported Inflation
CPI
Domestic CPI
Imported CPI
13
However, it is accompanied by strong domestic
demand
March
%
January
14
Upside risks in inflation have increased
Probability of inflation being higher than 4 and 5 percent
January 08
April 08
Larger than
Larger than Larger than
Larger than 5 %
4%
4%
5%
Sep-08
Dic-08
30
25
10
8
73
53
41
26
15
7
In response, the central bank has
increased its interest rate four times
TASAS DE INTERÉS DE REFERENCIA DEL BANCO CENTRAL
(En porcentajes)
since July
2007ntación
Repos y créditos de
Discount rate
regulación
monetaria
6
6,25
5,50
Tasa
de referencia
Reference
rate
del BCRP
5
4,75
4
3
Depósitos overnight
Deposit rate
en el BCRP
2
1
0
Set-03
Feb-04
Jul-04
Dic-04 May-05 Oct-05 Mar-06 Ago-06 Ene-07
Jun-07 Nov-07 Abr-08
16
This response aims at:
• Keep inflation expectations anchored to the central
bank inflation target.
• Bring output growth down to its potential level to
reduce upside inflation risks.
• Aminorate the impact of food prices on other
components of CPI inflation.
Some vulnerabilities, however, remain such
as dollarization, but are being reduced,
Financial Dollarization
Liabilities dollarization
Asset dollarization
18
On average, however, inflation has been one of
the lowest in Latin America
(Average 2002-2007 Annual Variation %)
Final remarks
• Relative price realigments seem to requiere
some reacction from central banks,
• This reaction should be strong enough to
guide expectations, but not to large to
generate a large cost in terms of output and
unemployment.