An increasing number of Latin American countries have been strengthening their monetary policy frameworks, using the monetary policy rate as their main instrument since the late 1990s. To decide whether to ease or tighten monetary conditions, policymakers typically compare the policy rate to the (short-run) neutral-interest rate – the rate that is consistent with stable inflation (at the central bank’s target) and a closed output gap. However, this rate can be time-varying as it is affected by changes in macroeconomic fundamentals and global interest rates.
The concept of the neutral-interest rate was originally suggested by Wicksell (1898), who defined the natural real interest as the long-run equilibrium rate that equates saving and investment (thus, being non-inflationary or neutral); and which in the absence of frictions would equal the marginal product of capital. We focus, however, on the short-run or ‘operationally’ neutral real policy interest rate, which might differ from the long-run natural interest rate (given the prevalence of market frictions in the short run).
Against this background, in a recent working paper (Magud and Tsounta 2012) we estimate neutral real-interest rates for ten Latin American countries that either have a full-fledged inflation-targeting regime in place (namely Brazil, Chile, Colombia, Mexico, Peru, and Uruguay) or have recently transitioned to it (Costa Rica, Dominican Republic, Guatemala, and Paraguay). Then, using the estimated neutral real interest rates we construct the interest-rate gap – the difference between the actual policy rate and the neutral – as a measure of the stance of monetary policy; and analyse the implications of this gap on output and inflation gaps over the past few years. Finally, given the recent increased use of macroprudential policies, we explore the their role in affecting the neutral real interest rates, and thus the stance of monetary policy.
Results: Neutral real interest-rate levels
Since there is no single best estimation method, and recognising differences in country characteristics and data availability, we use a battery of alternative methodologies, estimating a range of neutral real interest rates’ values for each country. Neutral real interest rates are usually found to be lower in relatively more economically and financially developed economies, and with better-established monetary frameworks. A notable exception is Brazil, where the neutral real-interest rate is among the highest in emerging markets (see Segura 2011 and Central Bank of Brazil 2012 for a discussion of the Brazilian interest-rate puzzle). We also observe that there has been a downward trend in these interest rates in recent years, possibly reflecting the region’s stronger economic fundamentals as well as easing global financial conditions that increased available savings in the region. Hence, as global conditions normalise over the medium term, it is likely that we will see some reversal in the recent trajectory of neutral real-interest rates.
Figure 1. Summary results from different methodologies for LA6 and other inflation targeters
Source: Authors' calculations.
Notes: 1Red dots denote end-August 2012 real policy rate (deflated by expected inflation). Rectangles represent values (end-May 2012) for NRIR ranges (excluding outliers). 2For Costa Rica, Guatemala and Uruguay a sub-sample of methodologies is used due to data limitations.
Figure 2. NRIR, EMBI spreads, and Fed funds rate (%)
Sources: Bloomberg; St. Louis Federal Reserve; and IMF staff calculations.
Notes: 1Average of Brazil, Chile, Colombia, Mexico, Peru, and Uruguay. 2Average of Brazil and Uruguay (dynamic Taylor rule for both). 3Average of Chile, Colombia, Mexico, and Peru. For Chile and Peru the NRIR is estimated using the savings-investment approach, for Colombia the dynamic Taylor rule is used, while for Mexico the implicit common stochastic trend.
Using the estimated neutral real-interest rate we construct the interest-rate gap, the difference between the actual and neutral real-interest rates. Using this gap to measure the stance of monetary policy as a proxy for domestic financial conditions, we observe that the interest-rate gap is correlated with:
- The output gap, possibly suggesting that central banks have been responding counter-cyclically to business cycle fluctuations and that monetary policy has been effective in fine-tuning the business cycle.
- Future GDP growth for most countries (typically with a nine-month lag). However, the impact on GDP dissipates as the interest rate approaches its neutral level.
- Deviations of inflation from target (the inflation gap), suggesting that central banks typically undertake restrictive monetary policies if the rate of inflation exceeds the target (and vice-versa).
Evaluating the current monetary stance
We find that as of end of August 2012, the stance of monetary policy seems to be appropriate in several countries with full-fledged inflation-targeting regimes, with countries moving towards a neutral stance in line with narrowing output gaps. Monetary policy remains stimulative – with actual interest rates below neutral – in Brazil, where there is evidence that growth is starting to pick up supported by the monetary stimulus in place. In Mexico, a policy rate below its neutral level is consistent with the ongoing fiscal consolidation and a broadly closed output gap.
Notwithstanding data limitations that may hinder the accuracy of the neutral real-interest rate estimates, Costa Rica, Dominican Republic, Guatemala, and Paraguay, seem to have an accommodative monetary stance despite generally closed output gaps. The latter result should be interpreted with caution, however, since changes in policy rates are not always reflected in market financial conditions in these countries given a relatively weak monetary transmission channel. In fact, muted inflationary pressures and tightening financial conditions have been recently observed in Costa Rica despite our estimated accommodative monetary stance and no change in the policy rate.
Macroprudential policies and the stance of monetary policy
In recent years, some countries in the region have also used less conventional measures to affect financial conditions, known as macroprudential policies. These include, among others, changing reserve requirements, imposing limits on currency mismatches or loan-to-value ratios, or imposing specific asset-risk weights. In this section, we speculate on how macroprudential policies might have affected our estimated neutral real (policy) interest rate, based on an event analysis for Brazil and Peru post-Lehman.
Following significant monetary easing amid the global financial crisis, both Brazil and Peru started implementing restrictive macroprudential policies in the second half of 2009 to contain domestic credit, without altering their policy rate (see Magud and Tsounta 2012). These measures reduced the estimated neutral policy rate, possibly through tightening credit conditions, and resulted in a less accommodative monetary stance (i.e. increase the interest-rate gap)1.
Figure 3. Monetary policy rate and interest gap (%)
Source: IMF staff calculations.
Notes: 1The interest-rate gap, computed as the monetary policy rate minus the NRIR, is based on the saving-investment approach (Brazil) and the dynamic Taylor rule (Peru) estimated neutral rates. 2t=0 represents July 2009 for Brazil and September 2009 for Peru.
Thus, macroprudential policies can supplement standard macro policies by affecting directly the credit channel, and thereby safeguarding financial stability without the unintended consequences on capital inflows that a rise in the policy rate might entail. We conjecture that in domestic overheating situations, macroprudential policies could complement conventional monetary policy by slowing down credit growth from (carry spread-driven) capital inflows (amid rising interest rates). For external shocks that increase capital inflows, these policies might even act as a substitute to conventional interest-rate policy, as they would directly tighten the credit channel without further increasing capital inflows. That said, more research is needed to better understand and quantify the effectiveness of macroprudential policies, including their impact on credit growth, output gap, and the neutral real-interest rate.
The neutral real-interest rate is one of the many unknowns with which monetary policymakers must grapple. Since no methodology estimates a single, correct neutral real-interest rate, central banks will continue to operate on the basis of a well-informed but inherently subjective judgement about unobserved variables such as the output gap and the neutral real-interest rate. At the end of the day, one of the main decisions of central banks is to cut or not cut. Our paper aims to help answer that question.
Central Bank of Brazil (2012), Inflation Report, September.
Magud, N E, and E Tsounta (2012), “To cut or not to cut? That’s the (Central Bank’s) Question. In Search of the Neutral Interest Rate in Latin America”, IMF Working Paper, 12/243, Washington, International Monetary Fund.
Segura-Ubiergo, A (2012), “The Puzzle of Brazil’s High Interest Rates”, IMF Working Paper, 12/62, Washington: International Monetary Fund.
Wicksell, K (1936 ), Geldzins und Guterpreise, translated by R F Kahn, ‘Interest and Prices’.
1 Results appear to be symmetric for macroprudential loosening measures.