The lag between excessive money growth and rising prices has often led policymakers to try to fine-tune the economy, hoping that easy money will have a quick impact on output and employment before showing up in inflation. But in today’s world of global capital markets and instant financial information, market participants react quickly to excessive money growth by rising nominal interest rates and moving assets to countries that have a credible commitment to sound money and the protection of property rights. (The loss of purchasing power due to monetary mismanagement and inflation in itself weakens private property rights.)
There is no doubt that as the Mexican economy follows the U.S. economy into recession there is room for monetary ease without the immediate threat of inflation. My warning is simply that Mr. Ortiz and his advisors should not use an increase in the demand for money (i.e., a fall in monetary velocity or the rate at which money circulates) as an excuse to return to excessive increases in the monetary base and the monetary aggregates.
Mr. Ortiz has reduced the growth of the monetary base (currency held by the public plus bank reserves) — the key variable that the central bank directly controls — from more than 43 percent in 1999 to about 11 percent last year and to an expected 10 percent this year. Since prices dance to money, inflation has declined from 12.3 percent in 1999 to 8.9 percent last year and is expected to end this year at 5.7 percent or less.
That reduction has helped Mexico attract capital and has stabilized the peso/dollar exchange rate. The fact that slow U.S. growth is dragging down the Mexican economy should not prevent the Mexican people from realizing the benefits of lower inflation.
It is well known that countries with persistently high inflation experience lower real growth than do countries with low inflation. Moreover, as inflation approaches zero, markets become more efficient and investment planning more certain.
Because of past mistakes, Mexico’s monetary credibility is still fragile. Inflation is still too high, implying that money growth is still too rapid. If the Banco de México wishes to permanently enhance its reputation, it must convince markets that its first principle is “Do no harm.” That means the Bank should concentrate on what it can do — control the monetary base — and limit itself to one target, long-run price stability, and not try to do what it cannot do — fine-tune the real economy.
The choice of a rule to achieve zero inflation is less important than a credible commitment to that objective. Commitment requires that the Bank realize that it cannot serve two masters: it cannot pursue an independent monetary policy aimed at stabilizing the price level and at the same time peg the nominal exchange rate, without imposing capital controls.
To his credit, Mr. Ortiz has focused on using monetary policy to strengthen the peso’s domestic purchasing power and believes that the market ought to set the exchange rate. In May he said, “Companies here have to realize there isn’t going to be a peso bailout, nor will we compromise on our inflation goals.”
The challenge is to bring inflation down further and for the Mexican Congress to make price stability the Bank’s sole responsibility. As in New Zealand, the governor of the central bank should be made liable for failure to end persistent inflation. By adopting a monetary rule, such as New Zealand’s inflation targeting rule, the Bank could institutionalize the goal of zero inflation.
Mr. Ortiz is moving toward inflation targeting, but Mexican monetary policy is still largely discretionary. Central bankers desire discretion because they think they can do better than a rule, but the experience of all central banks, including the Federal Reserve Bank, is not encouraging in that regard. When Fed chairman Alan Greenspan departs, the Fed will have a new head but no rule to guide it.
With U.S. inflation close to 3 percent and no anchor for the future value of the dollar, Mexico would do better to implement real reform and adopt a rule-based monetary regime than to follow the Fed.
Price stability, however, is not enough. To foster economic growth, Mexico needs to combat corruption by moving closer to the rule of law, to further liberalize internal and external trade, to privatize and cut the size of government, and to let freedom reign. That means people should be free to choose the currencies they wish to hold as legal tender so that the Banco de México is under constant pressure to improve its performance in achieving price stability.