VI Characterizing Monetary Policy

Luis Ignacio J&#xE1;come; Eric Parrado

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Author: Mr. Luis Ignacio Jácome¹ and Mr. Eric Parrado²

¹ 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
| ² 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Language:: English

Keywords:: OP; country; debt; government; policy regime; reaction function; appreciation trend; anti-inflation monetary policy; inflation pressure; Exchange rates; Real exchange rates; Central bank autonomy; Inflation targeting; Central America

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Abstract

Compared with the rest of Latin America, Central America has a history of low inflation (Figure 6.1).2 No country except Nicaragua has fallen into the clutches of hyperinflation, and during the 1990s and early 2000s, inflation dropped into single-digit rates. Nonetheless, price stability—defined in this chapter as the inflation in industrial countries—was never achieved, as inflation stalled above that in the rest of the Western Hemisphere. In addition, Central America appears vulnerable to a rebound of inflation—more than other countries in the region—as seen in the wake of the current oil price shock (Figure 6.2).

Compared with the rest of Latin America, Central America has a history of low inflation (Figure 6.1).² No country except Nicaragua has fallen into the clutches of hyperinflation, and during the 1990s and early 2000s, inflation dropped into single-digit rates. Nonetheless, price stability—defined in this chapter as the inflation in industrial countries—was never achieved, as inflation stalled above that in the rest of the Western Hemisphere. In addition, Central America appears vulnerable to a rebound of inflation—more than other countries in the region—as seen in the wake of the current oil price shock (Figure 6.2).

The downward trend in inflation across Central America has been accompanied by different patterns of monetary policy regimes. In particular, Panama and, more recently, El Salvador, adopted the U.S. dollar as legal tender; Costa Rica, Honduras, and Nicaragua have chosen an exchange rate-based policy regime; the Dominican Republic has in place a money targeting scheme; and Guatemala just shifted from money to inflation targeting. On these grounds, the fully dollarized economies have abdicated their right to conduct monetary policy, whereas those using the exchange rate as a nominal anchor maintained at best small room for maneuver. Only countries with a flexible exchange rate regime have been in a position to preserve the independent conduct of monetary policy—provided the exchange rate is effectively floating.

Today, the nondollarized Central American countries are revisiting how they conduct monetary policy, including in some cases a possible change of their policy regime. New developments are taking place, generally associated with growing regional integration with the U.S. economy. The Central American economies are increasingly open, dollarization is likely to continue at high levels, remittances from abroad are hitting record highs year after year, and, in general, countries in the region are expected to become more and more integrated into international capital markets. These trends inevitably pose challenges to the conduct of monetary policy, which explains the quest of central banks for the policy regime that better serves fulfilling their policy mandate under the new rules of the game.

This chapter discusses how monetary policies are conducted in Central America. Particular emphasis is given to the institutional underpinnings of monetary policy, the modalities of policy execution, and the factors underlying central bank reactions, mainly to inflation pressures.³ Despite the importance of monetary policy in an environment of elusive price stability in Central America, the analysis of monetary policy has not been addressed recently in the literature.⁴ Thus, the outcome of this chapter may offer information to practitioners and policymakers in these countries who are looking for the appropriate policy regime and its execution to achieve price stability.

Institutional Framework for Monetary Policy

During the last 15 years, all countries in the region have strengthened the institutional underpinnings for formulating and executing monetary policy. New central bank legislation was enacted, starting with Nicaragua in 1992 (and 1999) and followed by Costa Rica in 1995, Honduras in 1996 (and 2004), and Guatemala and the Dominican Republic in 2002.⁵ The central bank reform focused monetary policy on efforts to achieve and preserve price stability. To fulfill this objective, central banks were granted enhanced autonomy, although comparatively less than in other Latin American countries that also reformed central bank legislation during the 1990s.⁶ This section discusses the main features of central bank laws in relevant Central American countries, both across the region and compared with South American countries and Mexico. A stylized presentation of such legislation in each country is found in Table 6A.1.

Central Bank Reform

Following the reform of monetary legislation, central banks in the region no longer play the role of development banks with the aim of fostering growth. Today, they do not provide credit to specific sectors in the economy under preferential financial conditions, and they are not dependent on governments’ economic policy guidelines. Rather, they concentrate on achieving stability conditions as a necessary—although not sufficient—condition for economic growth. To distill the main features of current central bank legislation, this chapter emphasizes five main criteria: policy mandate, political autonomy, economic independence, financial autonomy, and accountability and transparency.⁷

The policy mandate of central banks in Central America is focused on preserving price stability, although in some countries the banks also give attention to the competitiveness of tradable activities. Except for Guatemala, where the Monetary Board (the governing body of the Bank of Guatemala) is charged with “preserving the liquidity and solvency of the banking system, safeguarding the stability and strengthening of the national savings,” the banks in the other four countries cite price stability as their policy objective.⁸ Central banks in Costa Rica and Honduras also have as an objective to preserve the external value of the domestic currency, together with the responsibility to assure the normal functioning of the payment system, which is also posted as an objective in Nicaragua’s central bank charter. The simultaneous focus on preserving the internal and external value of the domestic currency explains the pursuit of real exchange rate targeting in Costa Rica and Honduras. This duality in the central banks’ policy mandate is also prone to policy conflicts, as when the banks respond to capital inflows to prevent a real appreciation trend despite the disinflation effects.

The governing structure of central banks in Central America is less uniform, with some countries more than others featuring some degree of political autonomy. Despite progress on this front with respect to their historical submission to government policies, most central banks in the region still have only limited political autonomy de jure. In all Central American countries, central bank governors are appointed by the president, as was the case prior to the monetary reform. In addition, in most countries the executive branch has substantial leeway to remove central bank governors and other members of the board of directors, which implicitly puts central bank authorities in a vulnerable position.⁹ In turn, the term of the central bank governors coincides with that of the executive branch, and, notably, in the Dominican Republic it is only two years. As for the rest of the members of the board, their term varies from the two-year period in the Dominican Republic to an expanded term of 90 months in Costa Rica. On the other hand, it is remarkable that in the Dominican Republic and Guatemala, the private sector still has strong involvement in appointing the members of the Monetary Board, as is called the government body of the central bank in those countries—indirectly in the former country and directly in the latter (Table 6A.1).¹⁰ Putting all these provisions together, it can be concluded that in theory the legal reform in Central America did not untie the horizon of monetary policy decisions from the political business cycle.

Economic independence of central banks is common across the region. In general, central banks feature “instrument independence,” as they are empowered to freely execute monetary policy to attain their goals. In particular, central banks have the legal authority to use without interference monetary policy instruments to influence market interest rates, thereby potentially affecting inflation. They are legally restricted—and even prohibited, as in Guatemala—from extending credit to finance government spending, except for short-term advances to cope with seasonal liquidity shortages (Honduras and Nicaragua). Furthermore, in Costa Rica, Honduras, and Guatemala, the central bank serves as a legal filter to restrain pubic debt increases, as those banks have to provide a technical opinion about the appropriateness of new public debt issuance. What is not clear is whether central banks in Central America legally enjoy “target independence,” given that the new legislation does not stipulate central banks’ capacity for defining a policy target, such as inflation, independently from the government, although, in practice, governments in the region have proved to be quite supportive of de facto target independence.

However, economic autonomy is undermined in some countries by the lack of financial autonomy of central banks. On this front, there has been no major improvement following the reform of central bank legislation. This is particularly true in Costa Rica, Guatemala, and Honduras, where there is no legal provision to protect the integrity of central bank capital. Alternatively, in the Dominican Republic and Nicaragua, governments are compelled to make up for central bank losses if they cannot be compensated with statutory reserves. In practice, however, this legal mandate has not materialized, as both central banks feature a large negative capital, since they absorbed the bulk of the losses stemming from the banking crises that hit both countries during the early 2000s.¹¹ Weak financial autonomy raises market concerns about central banks’ abilities to effectively conduct monetary policy, as persistent large losses may undermine the operating independence of central banks and eventually curtail the effectiveness of monetary policy actions. This is because the accumulation of central bank losses may limit either their capacity to mop up excess liquidity or their ability to raise interest rates when conducting open-market operations, as they become an undesirable source of monetization that will require subsequent sterilization and additional costs.

Accountability and transparency requirements are a key innovation in central bank legislation in Central America. Before the legal reform, central banks in the region were basically committed to developing and publishing an annual report that took stock of the major economic developments of the country in a given year and focused on central bank policies, but not to the extent to which those policies attained their goals. The annual reports hence became a source primarily of academic interest, and were neither an instrument to monitor monetary policy nor a source of timely information for market participants. With the current legal provisions, central banks have become more accountable with respect to the autonomy they enjoy. They must appear before congress and report on the status of their policy goals. In Guatemala, accountability goes farther, as the central bank is required to disclose an explanatory monetary report twice a year. Transparency by law has also improved in most countries, as all central banks are required to disclose their financial statements, in some cases certified by an external private auditor (the Dominican Republic and Guatemala). Transparency conditions are also more stringent from a legal perspective in Guatemala, where the Bank of Guatemala is legally required to publish policy decisions to level the information playing field.

In sum, monetary policy in Central America has received an injection of institutional strength as a result of the reform of central bank legislation, though important flaws still remain. Progress is noticeable in focusing the mandate of central banks on combating inflation and preserving price stability and in granting banks operational autonomy. However, this progress is undermined in those countries where the central bank is also required to preserve the external value of the domestic currency because of the potential policy conflicts entailed vis-à-vis the objective of price stability. Also, political autonomy is still less than what is needed to assure the formulation of monetary policy, disregarding political business cycles. In addition, strengthening financial autonomy of central banks could enhance the effectiveness and credibility of monetary policy.¹² Finally, there is room to step up accountability and transparency procedures.

Measuring Central Bank Independence

As a result of legal reforms, central banks in Central America have enhanced their autonomy and institutional strength on all fronts. This improvement is captured through an index of legal central bank independence that, in essence, gives credit to central banks for their institutional capacity to arrest inflation and penalizes their role as government financers and active participants in political business cycles.

The index used in this chapter is based on the Cukierman (1992) index, which is the best known and most widely accepted metric to assess legal central bank independence. The index here incorporates the same four broad criteria included in the Cukierman index to capture key aspects of legal central bank independence, plus some additional features such as lender-of-last-resort and financial independence provisions. It also incorporates a fifth criterion, namely, accountability and transparency requirements.¹³ After applying different weights for each criterion, the resulting value of the index gives a score that varies in the scale between zero and one. Specifically, the first criterion measures the political autonomy of central banks by assessing how central bank governors and their board of directors are appointed, the length of their tenure—relative to the term of the executive branch—and the legal provisions for their removal. Thus, legal provisions that untie monetary policy from the political business cycle are rewarded (20 percent weight). The second criterion refers to the nature of the central bank mandate, assigning the highest marks to those banks that primarily pursue the objective of preserving price stability (15 percent). The third criterion gives credit to autonomous central banks in the formulation of monetary policy (15 percent). The fourth criterion primarily rewards central bank restrictions in lending provisions to the government, but also penalizes provisions that entail excessive room for monetization when central banks act as a lender of last resort. In addition, it assigns high marks for the legal basis that requires the government to preserve central banks’ financial integrity (40 percent). The fifth criterion positively evaluates central bank accountability and transparency requirements (10 percent).

Applying this index to central bank legislation—and the relevant aspects of national constitutions—it can be stated that central banks in Central America are today more independent than in their pre-reform period (Figure 6.3).¹⁴ Yet they still lag behind most central banks in South America and Mexico (Figure 6.4). A cluster analysis reveals the aspects where Central American central banks are by law less independent than those in South America and Mexico. Decomposing the index into the five main criteria described above, major weaknesses relate to political autonomy and policy mandate criteria (Table 6.1). Political autonomy is greater in most other central banks in the region because the appointment of government bodies’ and their dismissal generally requires legislative approval, and because their term exceed or overlaps electoral calendars, thereby reducing central banks’ exposure to potential political interference. In turn, the policy mandate of other Latin American central banks is focused on preserving price stability, which is less prone to policy conflicts than in Central America, where central bank charters sometimes assign them conflicting objectives.

Table 6.1.

Breakdown of Index of Legal Central Bank Independence: Central America versus South America and Mexico

Table 6.1.

Breakdown of Index of Legal Central Bank Independence: Central America versus South America and Mexico

	South America and Mexico	Central America
Total index as of 2005	0.769	0.704
Political autonomy	0.759	0.318
Central bank mandate	0.800	0.650
Monetary policy formulation	0.720	0.896
Central bank lending	0.753	0.820
Accountability	0.875	0.800

Table 6.1.

Breakdown of Index of Legal Central Bank Independence: Central America versus South America and Mexico

	South America and Mexico	Central America
Total index as of 2005	0.769	0.704
Political autonomy	0.759	0.318
Central bank mandate	0.800	0.650
Monetary policy formulation	0.720	0.896
Central bank lending	0.753	0.820
Accountability	0.875	0.800

However, central banks in Central America perform better when it comes to measuring autonomy for policy formulation, since other countries in Latin America, such as Argentina, Mexico, and Venezuela, face de jure influences from the executive and legislative branches in the formulation of exchange rate policy.¹⁵ Another factor underlying this result stems from the provision that gives powers to Central American central banks to restrict pubic debt expansion.

Both groups of countries rank nearly even in terms of lending restrictions to the government and accountability provisions. The latter mirrors the general consensus that exists relative to the inflationary effects of monetizing the fiscal deficit and the importance of holding central banks accountable as a key ingredient of their autonomy.

Central Bank Reform and Inflation

The years that followed the reform of central banks in Central America coincide in most countries with a period of lower inflation. The late reformers—the Dominican Republic and Guatemala—stand as exceptions. Inflation in the Dominican Republic soared in the aftermath of the full-fledged banking crisis in 2003, whereas in Guatemala it picked up due to the adverse effects of the oil shock in 2004–05. The other countries—including El Salvador in the 1990s—exhibit a decreasing inflation trend following the institutional reform of central banks, although in no country except for El Salvador did inflation converge to price stability, as measured by the rate of increase in prices in the industrial countries.

While the reform of central banks was not a triggering factor for reducing inflation in Central America, it served to lock in and preserve the momentum of an anti-inflation monetary policy. Indeed, there are no grounds to claim causality running from enhanced legal central bank independence to lower inflation in Central America because in almost all countries, inflation was already falling when the central bank legal reforms were adopted (Figure 6.5).¹⁶

Despite the success of the Central American countries in reducing inflation, there is no room for complacency. On one hand, inflation never converged to price stability, as happened in other Latin American countries. On the other hand, inflation picked up again in all countries in the midst of the current oil shock more than in other countries in the region. This is evident when one compares average inflation in Latin America during 2000–03 and 2004–05, and notes that in the latest period, when world oil prices hit record highs, inflation picked up the most in the Central American countries—except for Venezuela.¹⁷

This seemingly greater vulnerability of the Central American economies to real external shocks may be attributed, at least partially, to their relatively lower legal central bank independence vis-à-vis most other countries in Latin America. As pictured in Figures 6.6 and 6.7, the inverse correlation between legal central bank independence and inflation in Latin America increased in 2004–05, which suggests that more independent central banks have been in a stronger position to weather the inflationary effects of the recent oil shock.¹⁸

The notion behind this statement is that the greater the independence of central banks, the higher is their credibility, and hence, their capacity to mitigate the impact on inflation stemming from the pass-through from increasing world oil prices to domestic oil prices.¹⁹

This outcome cannot be explained because the Central American economies are oil importers, and hence, they shifted the whole increase in oil prices into domestic fuel prices. In fact, many countries in Latin America applied the same policy rule and yet they have achieved a better inflation performance. For instance, while Chile, Colombia, and Peru—with the most independent central banks in the region—allowed even a higher pass-through from world oil prices to domestic fuel prices, this effect was not factored into the consumer price index as much as in the Central American countries.²⁰ Why? Because although all countries accommodated the first-round effects from the oil shock, central banks in the three South American countries better managed to mitigate the impact on inflation resulting from the second-round effect. The latter is associated with a more effective conduct of monetary policy against inflation and/or stronger policy credibility.

A Snapshot of Monetary Policy Formulation and Execution

Central America has a long tradition of exchange rate-based policy regimes. Besides Panama’s century-old formal dollarization, El Salvador maintained a long period of a fixed exchange rate before adopting the dollar as its legal tender in 2001. Costa Rica, Honduras, and Nicaragua have followed an exchange rate targeting, with short interruptions in some of these countries during the early 1990s. This policy feature is not surprising given the structural economic characteristics of the Central American countries. They have widely open economies, closely integrated with the U.S. economy, and increasingly dollarized. Thus, the external sector is the main driver of economic activity, with most exports purchased by the U.S. market.²¹ In this environment and with relatively high inflation, dollarization became a natural response from economic agents, in particular in those countries where the exchange rate was not allowed to fluctuate.²² With the exchange rate playing a key role in affecting economic activity and price formation—and, in general, consumption and investment decisions—policymakers in Central America explicitly (due to a legal mandate) or implicitly have historically attached great importance to the external stability of domestic currencies.

While targeting the exchange rate favored anti-inflation efforts, it also imposed costs. In contrast with other Latin American countries, the use of the exchange rate to anchor inflation expectations in Central America—together with prudent fiscal policies—served well to reduce and maintain relatively low inflation. However, this also fostered dollarization among market participants without adopting appropriate hedging practices. In this environment, Central American central banks developed the “fear of floating” syndrome (Calvo and Reinhart, 2002) and entered into a vicious circle, where unhedged dollarization inhibited central banks from adjusting the exchange rate—to avoid damaging economic agents’ balance sheets—and the lack of exchange rate flexibility encouraged further unhedged dollarization. In addition, targeting the real exchange rate may have introduced inertia to inflation, thereby hampering its convergence to price stability.

In what follows, this section briefly reviews the main features of monetary policy formulation and execution in the Central American countries and identifies recent developments. We use a taxonomy of monetary policy regimes as a guideline to distinguish between money, exchange rate, and inflation targeting. This taxonomy provides a comprehensive and consistent analytical framework to characterize the nature of policy regimes and their associated operational arrangements (Table 6.2).

Table 6.2.

Taxonomy of Monetary Policy Strategies

Table 6.2.

Taxonomy of Monetary Policy Strategies

	Monetary Targeting	Exchange Rate Targeting	Inflation Targeting
Final policy goal	Inflation	Competitiveness	Inflation
Secondary policy goal	Competitiveness	Inflation	Competitiveness
Intermediate target	Money supply	Real exchange rate	Forecasted inflation
Operational target	Money base	Rate of crawl	Overnight interest rate
Primary shock absorber	Nominal exchange rate	International reserves	Nominal exchange rate
Secondary shock absorber	Real interest rate	Real interest rate	Real interest rate

Table 6.2.

Taxonomy of Monetary Policy Strategies

	Monetary Targeting	Exchange Rate Targeting	Inflation Targeting
Final policy goal	Inflation	Competitiveness	Inflation
Secondary policy goal	Competitiveness	Inflation	Competitiveness
Intermediate target	Money supply	Real exchange rate	Forecasted inflation
Operational target	Money base	Rate of crawl	Overnight interest rate
Primary shock absorber	Nominal exchange rate	International reserves	Nominal exchange rate
Secondary shock absorber	Real interest rate	Real interest rate	Real interest rate

The key notion behind this taxonomy is the identification not only of the final policy goal but also of the main shock absorber and the intermediate and operational targets consistent with each policy regime. Thus, money and inflation targeting allow the exchange rate to work as the main shock absorber in response to policy-induced or exogenous shocks, whereas exchange rate targeting relies on international reserves as its primary shock absorber. In addition, the practical experience shows that the real interest rate is a secondary shock absorber in all monetary policy strategies alike. On the other hand, money and inflation targeting share the same primary goal but differ as to which intermediate and operational targets they use to achieve their final policy goal. In turn, exchange rate targeting assigns priority to the competitiveness of tradable activities as a policy objective and relies on the real exchange rate and the rate of crawl as intermediate and operational targets, respectively.

Recent Trends in Policy Formulation

Formally, all Central American countries use financial programming as the cornerstone of monetary policy formulation, but they have adopted different monetary regimes (Table 6A.2). Costa Rica, Honduras, and Nicaragua follow an exchange rate targeting rule. In particular, Nicaragua has in place a crawling peg regime; Costa Rica recently introduced a band that substitutes a crawling peg; and Honduras has been operating with a wider band, although effectively it was a crawling peg since the rate has been persistently evolving along the lower end of the exchange rate band.²³ In turn, the Dominican Republic and Guatemala allow the exchange rate to adjust, although, in practice, with limitations,²⁴ and are classified as money and inflation targeters, respectively (IMF, 2005). Thus, as small and very open economies, most countries in Central America rely on the exchange rate as the main factor guiding inflation expectations.

While in theory targeting the exchange rate leaves no room for policy maneuver, Central American central banks working under exchange rate targeting identify monetary aggregates as intermediate targets (see Table 6A.1). By definition, targeting the exchange rate makes monetary policy endogenous—provided there is perfect capital mobility. So, how can we explain this seemingly contradiction? From a practical standpoint, this is because Central American central banks are molded from the traditional financial programming framework, and hence, they target monetary aggregates and tend to adjust interest rates should deviations from targets occur. In any case, this can operate—in the short-run—because despite having open capital accounts, the Central American countries feature less than capital mobility.²⁵ As a result, the so-called “impossible trinity” may be less binding, and hence, central banks may have some scope to affect the money supply.²⁶

In the absence of convergence of inflation to price stability, some countries in the region are starting to revisit their monetary policy regimes. In particular, Guatemala recently introduced an inflation targeting regime after having gradually abandoned its previous money targeting strategy. The reform of the organic law of the Bank of Guatemala in 2002 was a milestone to strengthen the bank’s autonomy from the government. Based on this enhanced operational autonomy, the Bank of Guatemala has recently made progress in fostering its modeling and inflation forecasting capabilities, and in boosting the transparency of monetary policy formulation and execution, all of which are key building blocks for an inflation targeting regime.²⁷ Costa Rica seems to be moving in the same direction. However, its transition to inflation targeting will be more challenging as it also requires shifting to a flexible exchange rate regime after more than 20 years of maintaining a crawling peg. This transition has already started with the recent introduction of an exchange rate band that replaces the previous crawling peg regime.

How does this brief characterization of monetary policy regimes on the basis of banks’ information in Central America reconcile with actual central bank data? The information in Table 6.3 provides preliminary answers to this question. It shows the volatilities of relevant macro-monetary variables during 2000–05 as a way of getting a flavor of the policy regime that is currently in place in the five Central American countries. We then compare the results with similar computations for other Latin American countries, including an exchange rate targeter such as Bolivia, and inflation targeters such as Chile, Colombia, Mexico, and Peru.

Table 6.3.

Volatilities of Selected Macroeconomic Variables, 2000–05

(Standard deviations)

^¹The calculations cover the period 1996–2002 in the Dominican Republic and 2002 onward in Nicaragua in order to avoid capturing the effects on monetary variables of their systemic banking crises. In Guatemala, the period starts after late 2001, when a large sovereign large debt placement caused a once-and-for-all 50 percent increase in international reserves.

^²For Nicaragua, given the lack of a consistent central bank interest rate series, the one-month deposit rate in the commercial banks is used as an imperfect substitute.

Table 6.3.

Volatilities of Selected Macroeconomic Variables, 2000–05

(Standard deviations)

	Nominal Depreciation	Reserves (% change)	Real Interest Rates
	Central America and the Dominican Republic
Costa Rica	0.13	7.54	2.19
Dominican Republic¹	1.14	9.88	3.11
Guatemala¹	0.71	6.69	1.74
Honduras	0.16	2.92	1.42
Nicaragua^1,2	0.05	7.40	3.75
	Other Selected Countries in Latin America
Bolivia	0.27	8.43	3.67
Chile	2.51	2.62	2.60
Colombia	2.23	2.41	1.36
Mexico	1.71	2.89	2.52
Peru	0.93	3.04	4.72

^²For Nicaragua, given the lack of a consistent central bank interest rate series, the one-month deposit rate in the commercial banks is used as an imperfect substitute.

Table 6.3.

Volatilities of Selected Macroeconomic Variables, 2000–05

(Standard deviations)

	Nominal Depreciation	Reserves (% change)	Real Interest Rates
	Central America and the Dominican Republic
Costa Rica	0.13	7.54	2.19
Dominican Republic¹	1.14	9.88	3.11
Guatemala¹	0.71	6.69	1.74
Honduras	0.16	2.92	1.42
Nicaragua^1,2	0.05	7.40	3.75
	Other Selected Countries in Latin America
Bolivia	0.27	8.43	3.67
Chile	2.51	2.62	2.60
Colombia	2.23	2.41	1.36
Mexico	1.71	2.89	2.52
Peru	0.93	3.04	4.72

^²For Nicaragua, given the lack of a consistent central bank interest rate series, the one-month deposit rate in the commercial banks is used as an imperfect substitute.

The results raise doubts about the true policy framework prevailing in some of the Central American countries. They only allow us to label Costa Rica and Nicaragua, and to a lesser extent Honduras—because of the low variability of international reserves—as exchange rate targeters. On the other hand, it appears more difficult to ascertain the policy regime embraced by the Dominican Republic and, in particular, Guatemala. These two countries feature more exchange rate flexibility than the former but far less flexibility than the inflation targeting countries in Latin America, which suggests that Guatemala and the Dominican Republic care systematically about exchange rate stability. On these grounds, Guatemala does not seem to be working yet as an inflation targeting but rather as a hybrid of inflation and exchange rate targeting, given the high variability of international reserves. The performance of real interest rates—with respect to contemporaneous inflation—does not exhibit major differences across countries, which suggests that they all use real interest rates as shock absorber.

Modernization of the Operational Framework

Today, all countries in Central America rely on indirect instruments to conduct monetary policy. Reserve requirements are used in all countries, but they are not envisaged as a dynamic tool of monetary control, except probably in Nicaragua, which tightens reserve requirements when the target of international reserves is challenged. In general, reserve requirements in most countries have remained over time almost invariably at about 15 percent (Table 6A.2). From another angle, reserve requirements are used as a buffer to cope with potential liquidity shortages in the banking system. In Honduras, they are also used as a buffer to cope with the limitations imposed by financial dollarization on the central bank’s role as lender of last resort by establishing discriminatory rates against foreign currency deposits.

With the aim of shaping operational autonomy now established in the new central bank charters, most countries in Central America have created open market operation committees. The new institutional arrangement is intended to strengthen short-term policy responsiveness and separate the execution from the formulation of monetary policy—the latter typically a responsibility of central bank boards in these countries. This reform is particularly important in Central America, given the limited political independence of central banks, as was discussed earlier in this chapter. Yet, the institutional reform has not borne all its fruit, as the conduct of monetary policy exhibits important flaws.

In most countries in Central America, monetary policy lacks effectiveness. The main instrument of monetary policy is open market operations, which are used to steer monetary aggregates within the limits established in the financial programming of central banks. However, the effectiveness of open market operations is hindered because they are not executed under market premises.²⁸ In particular, interest rates are not allowed to adjust to reflect market preferences and expectations. Central banks use cut-off rates to restrain interest rate increases either because of potential political pressures that see such increases as undermining economic growth, or due to the limitations imposed by the already-weak financial position of most central banks.²⁹ Under these conditions, a meaningful yield curve is absent in all countries. This restricts central banks from extracting valuable information about markets’ inflation expectations. In addition, central banks do not aim to manage short-term liquidity, and hence, interbank short-term interest rates in some countries tend to be volatile, a situation exacerbated by the relative shallowness of the money markets.

Recently, Costa Rica, the Dominican Republic, Guatemala, and Honduras established a policy rate, typically a short-term interest rate. However, it has had little effect on improving the transmission mechanism of monetary policy.³⁰ With this innovation, central banks seek to use an operational instrument as a way of boosting the effectiveness of monetary policy and signaling changes in the monetary policy stance. In practice, however, the policy rate is playing little or no role, as its changes are rarely followed by market interest rates. The lack of proper liquidity management by central banks helps to explain this disconnection, as the banks’ policy rate does not reflect the underlying liquidity conditions. In Costa Rica and Honduras, the effectiveness of the policy rate is limited by the exchange rate regime, given that the rate of crawl is effectively the operational target and because this policy regime reduces the capabilities of central banks to manage systemic liquidity.

Another factor hindering the effectiveness of monetary policy during the last two years stems from persistent capital inflows. To cope with this situation, central banks have intervened in the foreign exchange market to head off appreciations of domestic currencies, thereby fueling a persistent increase of international reserves. At the same time, to prevent excessive monetization, central banks have stepped up sterilization through open market operations, and in many cases, via standing facilities—typically of short-term maturities—amid fears of exacerbating central bank losses and perpetuating capital inflows due to the premium paid in domestic interest rates vis-à-vis dollar interest rates. Eventually, liquidity surplus has prevailed in most countries, which tends to limit the effectiveness of monetary policy due to the reduced ability of central banks to influence commercial banks’ short- and hence long-term interest rates.

Empirical Regularities Supporting the Characterization of Monetary Policy

This section examines monetary policy in the Central American countries by estimating the reaction functions of central banks. The purpose of this exercise is to assess, on a preliminary basis, how monetary policy has in practice reacted to recent shifts in underlying economic fundamentals, especially inflation, in each country. The main idea behind the proposed analysis is to ascertain whether central banks work under clear and predictable rules that would make them more likely to deliver lower inflation rates over time. This exercise also allows us to verify empirically the previous characterization of monetary policy spelled out from central banks’ information.

Methodology

The analysis focuses on the standard reaction function based on the interest rate as the policy instrument, but also evaluates exchange rate crawl and money reaction functions. Expanding the analysis from the standard approach is warranted given the heterogeneity of monetary policy regimes observed in Central America, which include money, exchange rate, and inflation targeting.³¹

Against this backdrop, this chapter considers a mix of policy instruments to separately estimate several policy reaction functions along the general lines of Taylor (1993), Parrado (2004), and McCallum (1988), depending on the instrument considered:³²

\begin{matrix} i_{t} = (1 - ρ) α + (1 - ρ) {βπ}_{t + n} + (1 - ρ) {γx}_{t + m} + ρ i_{t - 1} + ε_{t} & (1) \\ Δ e_{t} = (1 - ρ) α + (1 - ρ) {βπ}_{t + n} + (1 - ρ) {γx}_{t + m} + ρΔ e_{t - 1} + ε_{t} & (2) \\ Δ m_{t} = (1 - ρ) α + (1 - ρ) {βπ}_{t + n} + (1 - ρ) {γx}_{t + m} + ρΔ m_{t - 1} + ε_{t} & (3) \end{matrix}

where i is a policy interest rate or a repo rate, π is the inflation rate, x is the output gap, m is a monetary aggregate defined as the intermediate target (typically the money base), and e is the exchange rate. The method of estimation is the generalized method of moments (GMM).

The methodological approach is one of “letting the numbers talk,” and hence, we estimate all three equations for each country regardless of the a priori characterization of the current policy regime. Given the seeming inconsistency between Central American central banks’ characterization of their policy regime—according to Appendix 6A.2—and how, in principle, their monetary policy really appears to operate (Table 6.3), we estimate all three reaction functions, although placing more emphasis on the first two equations, which better picture monetary policy management in most countries in Central America.

Equation (1) provides the critical analytical framework to assess the reaction functions of central banks. On the one hand, monetary-based policy regimes adjust interest rates to affect monetary aggregates and, indirectly, inflation. On the other hand, even central banks that have adopted exchange rate crawls may use interest rates as a policy instrument to defend the peg, reduce inflation, or protect international reserves in times of financial turbulence. In turn, inflation targeting countries adjust the interest rate as a policy variable to guide expectations and steer actual inflation toward forecasted inflation.

Equation (2) usually provides valuable information about countries using an exchange rate crawl as a policy instrument, but it may also be relevant when it comes to floating exchange regimes. Typically, this equation assumes that the rate of crawl is regularly adjusted to compensate for differentials of inflation with respect to its “target.” A clear example of this policy approach is found in Singapore, where the monetary authorities presume that small open economies cannot manage interest rates and only have control over the exchange rate.³³ In some countries, this policy rule may also serve to compensate for differentials of actual from potential output. Under this approach, this policy rule may not be as relevant in Central America. While targeting the exchange rate may give some signals about the long-term direction of exchange rate policy, in the short run this information has less of a foundation in Costa Rica and Nicaragua, as their central banks tend to favor a predictable path for the exchange rate, and hence do not use it as a policy instrument on a short-term basis. Honduras, in turn, can adjust the rate of crawl on a short-term basis, and hence, has the potential for using it as a policy instrument either to moderate inflation or to target a real exchange rate. On the other hand, equation (2) may also be relevant to gauge whether central banks using flexible exchange rate regimes in reality care about the competitiveness of the economies’ tradable activities, which may materialize by means of interventions in the foreign exchange market.

The specification in equation (3) is tailored to capture the policy reaction of central banks that directly adjust monetary aggregates in response, for example, to inflation pressures. Thus, it is applicable to central banks that have in place a flexible exchange rate regime, which makes room for exogenous management of monetary aggregates. In particular, this equation addresses the question of whether the central bank adjusts the money base in response to inflation or other policy shocks. The experiment may also apply to exchange rate targeters like Honduras and Nicaragua, which have negotiated successive economic programs with the IMF during the period of analysis. The policy framework associated with these economic programs envisages that central banks should tighten monetary policy to cope with inflation pressures.

As a baseline specification, we consider output and inflation as the standard targets of monetary policy in the reaction functions of central banks. Depending on the reaction function, we then include other objectives such as the exchange rate, the real exchange rate, and international reserves into the baseline specification and analyze the behavior of some key model parameters. In the baseline specification, we pay special attention to the parameters associated with inflation and, to a lesser extent, output. This is because, as discussed earlier, fighting inflation is a key feature of the mandate of Central American central banks, whereas output stability or fostering economic growth is no longer an objective in their charters.

Data

The analysis is based on monthly data for 1996–2005.³⁴ The selected period corresponds to the time span that follows the inception of the new institutional setting that granted most central banks enhanced operational autonomy. Choosing this period allows for isolating the analysis from the first half of the 1990s, when Central America experienced a steep decrease in inflation, which would probably distort the empirical analysis. To control for the adverse effects of systemic banking crises on monetary policy, we included dummy variables. In particular, the estimations control for the expansionary monetary stance associated with the central banks’ involvement in the full-fledged banking crises that hit Nicaragua in 2001–02 and the Dominican Republic in 2003. In addition, to test whether the Bank of Guatemala has been lately formulating monetary policy as an inflation targeter, we break down the analysis for Guatemala into two periods.³⁵

The data series’ were obtained directly from each central bank. The quality of the data is rather good, except for the monthly series of economic activity, which is an imperfect substitute for a GDP series. On a country basis, a consistent series for central bank interest rates in Nicaragua is not available, and hence, we used the one-month deposit interest rate in commercial banks as an imperfect substitute. In addition, measures of output gap are not available, and hence, output is used directly. With these caveats in mind, we should be cautious in being too conclusive when interpreting the outcome of the empirical assessment of central bank reaction functions in Central America, particularly when it comes to analyzing the response of policy instruments to output behavior.

Estimations

The results stemming from this quantitative analysis shed some light on central banks’ actual policy implementation. In particular, they show that, regardless of the monetary regime, all central banks respond by raising interest rates in light of inflation pressures, but the magnitude of the response differs across countries such that some central banks are thus more effective than others in coping with inflation pressures. The estimations also stress that some central banks simultaneously seek to preserve exchange rate stability—which can be a source of policy conflicts. The estimations also reveal the difficulties in trying to effectively target the real exchange rate. Finally, they suggest that most central banks tighten money to tackle inflation, regardless of whether they target money or the exchange rate.

Interest Rate Reaction Functions

Assuming a forward-looking horizon of zero months, the coefficients associated with expected inflation are positive and significant in all countries. They indicate that in response to a 1 percent change in inflation, the interest rate is modified in the range of 0.6 to nearly 2 percent depending on the country (Table 6.4). The coefficient associated with inflation is much higher than 1 in Costa Rica and, in particular, Guatemala—in both periods alike—which implies that the real interest rate moves in the same direction as the nominal rate. This means that the interest rate is temporarily altered to affect aggregate demand, and thus, inflation (the aggregate demand function is then negatively sloped with respect to the inflation rate). On the other hand, the value of the inflation coefficient in the Dominican Republic, Nicaragua, and Honduras suggests a partial accommodative reaction, as the increase in nominal interest rates in response to inflationary pressures is insufficient to prevent the real interest rate from falling. This outcome could be explained by the fact that the central banks in these two countries may also use other policy instruments to cope with inflation pressures.

Table 6.4.

Interest Rate Reaction Function of Central Banks, 1996–2005

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^{^a}Guatemala-1 is based on the period from 1996 to 2005.

^{^b}Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^¹Dummy variables are used to control for banking crises periods.

^²Estimations for the Dominican Republic are based on quarterly data.

Table 6.4.

Interest Rate Reaction Function of Central Banks, 1996–2005

	Lagged Instrument	Constant	Inflation	Output	Exchange Rate
Costa Rica	1.05*	–0.16	1.25*	–0.27	2.53*
	–90.03	–2.17	–3.21	–1.07	–3.98
Guatemala-1^a	0.94*	–0.11	1.98*	1.11*	0.66*
	–155.98	–2.88	–5.32	–2.14	–5.68
Guatemala-2^b	0.96*	–0.06	1.93*	–0.21	0.48*
	–476.23	–3.67	–9.17	–0.69	–4.98
Honduras	0.93*	–0.01	0.62*	0.62*	0.89*
	–72.89	–0.46	–1.72	–4.99	–3.38
Nicaragua¹	0.96*	–0.06	0.71*	–0.02	0.73*
	–87.62	–1.83	–2.18	–0.17	–5.10
Dominican Republic^1,2	0.40	–0.07	0.70*	2.19*	0.03
	–1.41	–0.77	–4.36	–2.05	–0.25

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^{^a}Guatemala-1 is based on the period from 1996 to 2005.

^{^b}Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^¹Dummy variables are used to control for banking crises periods.

^²Estimations for the Dominican Republic are based on quarterly data.

Table 6.4.

Interest Rate Reaction Function of Central Banks, 1996–2005

	Lagged Instrument	Constant	Inflation	Output	Exchange Rate
Costa Rica	1.05*	–0.16	1.25*	–0.27	2.53*
	–90.03	–2.17	–3.21	–1.07	–3.98
Guatemala-1^a	0.94*	–0.11	1.98*	1.11*	0.66*
	–155.98	–2.88	–5.32	–2.14	–5.68
Guatemala-2^b	0.96*	–0.06	1.93*	–0.21	0.48*
	–476.23	–3.67	–9.17	–0.69	–4.98
Honduras	0.93*	–0.01	0.62*	0.62*	0.89*
	–72.89	–0.46	–1.72	–4.99	–3.38
Nicaragua¹	0.96*	–0.06	0.71*	–0.02	0.73*
	–87.62	–1.83	–2.18	–0.17	–5.10
Dominican Republic^1,2	0.40	–0.07	0.70*	2.19*	0.03
	–1.41	–0.77	–4.36	–2.05	–0.25

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^{^a}Guatemala-1 is based on the period from 1996 to 2005.

^{^b}Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^¹Dummy variables are used to control for banking crises periods.

^²Estimations for the Dominican Republic are based on quarterly data.

The estimations also show that central banks, except for the Dominican Republic, react positively and significantly to exchange rate depreciations. This relationship has at least two possible readings, depending on the monetary policy regime in each country, that eventually point to a “fear of floating” scenario. In an environment of exchange rate targeting (Costa Rica, Honduras, and Nicaragua), central banks may increase interest rates in response to exchange rate depreciations to preserve a covered interest parity condition. Rising interest rates may also be the case—in particular in Costa Rica because of the high value of the exchange rate coefficient—to defend the pre-announced exchange rate path, thereby preventing major disturbances in the foreign exchange market, which potentially could have a negative impact on market participants’ balance sheets. Alternatively, when it comes to money and inflation targeting, this reaction may show that central banks also care about exchange rate stability.

The affection that central banks hold for preserving the external stability of their currencies could be justified on many possible fronts. One explanation is that central banks believe that exchange rate pass-through to prices is significant and hence they need to cap exchange rate swings. This is a plausible explanation in small and very open economies, like those of Central America, where exchange rate performance has a great impact on price formation. An alternative rationalization is that central banks in Central American economies assign a relatively higher weight to the exchange rate to maintain trade competitiveness and even financial stability. Regarding the latter, Calvo and Reinhart (2002) argue that the “fear of floating” found in a number of emerging markets is explained by the high risk premium they have to pay because of their low institutional and policy credibility. The resistance to floating the exchange rate may be predominantly high in countries with shallow markets, which are susceptible to herd behavior. Also, financial imperfections such as a large amount of external debt or debt indexed to the exchange rate, as in Nicaragua and Costa Rica, make the case for preventing exchange rate fluctuations. Eichengreen (2002) and Goldstein and Turner (2004) have recently highlighted the adverse consequences of exchange rate depreciations in countries with a high degree of dollarization. Sharp currency depreciations can cause widespread bankruptcies, as foreign exchange credit risk has an adverse effect on unhedged borrowers. This rather unconventional and contractionary impact of exchange rate depreciations makes it necessary for central banks to raise interest rates defensively against major exchange rate shocks.

Despite the caveats associated with measures of output in the Central American countries, it is worth cautiously mentioning the seemingly countercyclical role of some central banks. In particular, Guatemala, during the money targeting phase, Honduras, and especially the Dominican Republic seem to reduce interest rates to confront a slowdown in economic activity.

In addition, some central banks adjust inversely interest rates to changes in international reserves. In particular, the central banks in Nicaragua, the Dominican Republic, and especially Costa Rica appear to raise interest rates to safeguard the stability of international reserves (not reported). One can understand this behavior as an effort of central banks to underpin the stability of the exchange rate, which in countries with high capital mobility critically hinges on preserving an appropriate level of international reserves.

Exchange Rate Crawl Reaction Function

While the estimates of this reaction function have generally resulted in unstable and rather erratic coefficients, depending on the combination of endogenous variables, some interesting results are worth mentioning from our experiments.³⁶ We run a baseline scenario with a forward-looking horizon of zero months, except for the real exchange rate, which is lagged one period.³⁷ The estimates show that, among the exchange rate targeters, only Costa Rica designs its exchange rate policy with the aim of preserving the competitiveness of domestic activities, given that the coefficient associated with the inflation rate is positive and statistically significant (Table 6.5). Strikingly, the results also show that Guatemala features an accommodative exchange rate policy with respect to inflation, which points in the direction of a central bank that cares about tradable activities—as observed before—despite being in transition to inflation targeting. In this connection, an accommodative exchange rate policy in response to inflation may cast doubts on market participants about the true primary objective of the central banks. Seeking to simultaneously preserve the internal and external value of domestic currencies may become mutually incompatible, particularly when the country experiences exchange rate appreciation trends.

Table 6.5.

Exchange Rate Crawl Reaction Function, 1996–2005

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^¹Guatemala-1 is based on the period from 1996 to 2005.

^²Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^³A fall in the real exchange rate implies an appreciation and vice versa.

^⁴Dummy variables are used to control for banking crises periods.

^⁵Estimations for the Dominican Republic are based on quarterly data.

Table 6.5.

Exchange Rate Crawl Reaction Function, 1996–2005

	Lagged Instrument	Constant	Inflation	Output	Real Exchange Rate (t–1)¹
Costa Rica	0.94*	0.02*	0.39*	0.55*	0.06
	–129.02	–1.41	–3.71	–8.66	–1.63
Guatemala-1²	0.65*	0.03	–0.18	0.92*	–0.69*
	–9.18	–1.62	–0.74	–5.40	–9.08
Guatemala-2³	0.51*	–0.03*	1.16*	–1.21*	–0.77*
	–11.60	–3.65	–13.44	–10.52	–17.26
Honduras	1.04*	0.12	–0.78	0.25	0.16
	–49.35	–1.12	–0.63	–1.47	–0.35
Nicaragua⁴	1.01*	0.10	–0.15	0.2	–0.35
	–187.74	–1.24	–0.18	–0.47	–1.49
Dominican Republic^4,5	0.69*	0.54	–2.82	–3.90*	2.33
	–2.76	–1.04	–1.07	–0.90	–1.34

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^¹Guatemala-1 is based on the period from 1996 to 2005.

^²Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^³A fall in the real exchange rate implies an appreciation and vice versa.

^⁴Dummy variables are used to control for banking crises periods.

^⁵Estimations for the Dominican Republic are based on quarterly data.

Table 6.5.

Exchange Rate Crawl Reaction Function, 1996–2005

	Lagged Instrument	Constant	Inflation	Output	Real Exchange Rate (t–1)¹
Costa Rica	0.94*	0.02*	0.39*	0.55*	0.06
	–129.02	–1.41	–3.71	–8.66	–1.63
Guatemala-1²	0.65*	0.03	–0.18	0.92*	–0.69*
	–9.18	–1.62	–0.74	–5.40	–9.08
Guatemala-2³	0.51*	–0.03*	1.16*	–1.21*	–0.77*
	–11.60	–3.65	–13.44	–10.52	–17.26
Honduras	1.04*	0.12	–0.78	0.25	0.16
	–49.35	–1.12	–0.63	–1.47	–0.35
Nicaragua⁴	1.01*	0.10	–0.15	0.2	–0.35
	–187.74	–1.24	–0.18	–0.47	–1.49
Dominican Republic^4,5	0.69*	0.54	–2.82	–3.90*	2.33
	–2.76	–1.04	–1.07	–0.90	–1.34

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^¹Guatemala-1 is based on the period from 1996 to 2005.

^²Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^³A fall in the real exchange rate implies an appreciation and vice versa.

^⁴Dummy variables are used to control for banking crises periods.

^⁵Estimations for the Dominican Republic are based on quarterly data.

The results also show that maintaining a stable real exchange rate is a difficult endeavor. This may be due to the use of a backward-looking rule in announcing the future path of the peg in an environment of unstable inflation, which makes it more difficult to target a given real exchange rate. Strikingly, by managing the exchange rate more flexibly—although intervening in the exchange rate market—the Bank of Guatemala has preserved a real exchange rate parity, which signals its concern for an exchange rate that is either appreciated or depreciated in real terms. The failure of most central banks in Central America to maintain a given real exchange rate level is in accordance with the conventional wisdom that claims that real exchange rates are endogenous in the short run.

Money-Base Reaction Function

The results from the money reaction function are mixed for both money and exchange rate targeters. Among the former, only the Bank of Guatemala adjusts the money base to cope with inflation pressures, whereas the coefficient of inflation in the Dominican Republic has the expected sign but is not statistically significant. The value of the coefficients also suggests that the use of the money base to tackle inflation pressures has declined in Guatemala during the transition to inflation targeting. As for the exchange rate targeters, despite the limitations that targeting the exchange rate impose on the control of monetary variables, the central banks in Nicaragua and, in particular, Honduras, seem to have a strong capacity to tighten the money base in response to inflation (Table 6.6).

Table 6.6.

Central Banks’ Money Reaction Function, 1996–2005

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^¹Guatemala-1 is based on the period from 1996 to 2005.

^²Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^³Dummy variables are used to control for banking crises periods.

^⁴Estimations for the Dominican Republic are based on quarterly data.

Table 6.6.

Central Banks’ Money Reaction Function, 1996–2005

	Lagged Instrument	Constant	Inflation	Output	Exchange Rate
Costa Rica	0.90*	–0.40*	2.25	0.65	3.34*
	–52.84	–2.74	–1.61	–0.78	–1.83
Guatemala-1¹	0.87*	0.10	–2.38*	7.95*	–0.82*
	–22.24	–1.23	–2.73	–3.78	–2.22
Guatemala-2²	0.57*	0.19*	–0.79*	–1.16*	0.51*
	–12.90	–16.19	–6.02	–2.31	–4.98
Honduras	0.93*	0.67*	–6.99*	–3.26*	5.39*
	–43.85	–3.37	–2.75	–2.54	–2.84
Nicaragua³	0.54*	0.21*	–1.20*	–0.41*	1.26*
	–10.74	–5.77	–2.94	–3.13	–4.88
Dominican Republic^3,4	0.38*	0.01	0.23	1.33	0.23
	–0.98	–0.05	–0.40	–0.64	–0.85

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^¹Guatemala-1 is based on the period from 1996 to 2005.

^²Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^³Dummy variables are used to control for banking crises periods.

^⁴Estimations for the Dominican Republic are based on quarterly data.

Table 6.6.

Central Banks’ Money Reaction Function, 1996–2005

	Lagged Instrument	Constant	Inflation	Output	Exchange Rate
Costa Rica	0.90*	–0.40*	2.25	0.65	3.34*
	–52.84	–2.74	–1.61	–0.78	–1.83
Guatemala-1¹	0.87*	0.10	–2.38*	7.95*	–0.82*
	–22.24	–1.23	–2.73	–3.78	–2.22
Guatemala-2²	0.57*	0.19*	–0.79*	–1.16*	0.51*
	–12.90	–16.19	–6.02	–2.31	–4.98
Honduras	0.93*	0.67*	–6.99*	–3.26*	5.39*
	–43.85	–3.37	–2.75	–2.54	–2.84
Nicaragua³	0.54*	0.21*	–1.20*	–0.41*	1.26*
	–10.74	–5.77	–2.94	–3.13	–4.88
Dominican Republic^3,4	0.38*	0.01	0.23	1.33	0.23
	–0.98	–0.05	–0.40	–0.64	–0.85

Note: t-statistics in parentheses. *Coefficients are statistically significant at the 5 percent level.

^¹Guatemala-1 is based on the period from 1996 to 2005.

^²Guatemala-2 corresponds to late 2001 to 2005, when the Bank of Guatemala started to formulate and implement monetary policy as an inflation targeter.

^³Dummy variables are used to control for banking crises periods.

^⁴Estimations for the Dominican Republic are based on quarterly data.

One possible explanation for this puzzling outcome is that the assumption of perfect capital mobility, in particular in Honduras, but also in Nicaragua, is less binding, which makes room for central banks to exercise some monetary control. This explanation is mostly relevant for Honduras because the surrender requirement of foreign currency to the central bank inhibits the creation of a foreign exchange market.³⁸ In addition, in both countries the money market is shallow, which makes interest rate adjustment sluggish. The use of monetary aggregates to cope with inflation pressures in Honduras and Nicaragua, despite being exchange rate targeters, may also be associated with IMF programs that have been in effect in these two countries during most of the period of analysis. As noted, standard IMF programs require central banks to observe quarterly monetary targets as performance criteria.

Conclusions

Most Central American countries have succeeded in reducing inflation to the single-digit range. This outcome is not only the result of a drop in inflation in the rest of the world; it also follows from the Central American nations having maintained sound macroeconomic policies and adopted far-reaching structural reforms over more than 10 years. A key component of this macroeconomic strategy has been to give central banks enhanced autonomy to formulate and execute monetary policy. Today, central banks in Central America, like their peers in the rest of the region, are no longer development banks. They focus their policies on fighting inflation, although in some countries this sometimes conflicts with the parallel objective of preserving the external value of domestic currencies.

Despite the progress achieved by the Central American central banks in reducing inflation, there is no room for complacency. Inflation in most countries is still high by regional and world standards. Moreover, central banks are still in the process of building their reputation and credibility, which is expected not only to help them further reduce and stabilize inflation, but also to better withstand exogenous events such as the recent oil shock that shifted inflation in some countries to low two-digit rates.

While all central banks in the region today enjoy more solid institutional strength, additional steps should be taken to underpin their credibility and achieve better inflation results. Progress is still necessary in four main areas: (1) clarify the mandate of central banks to eliminate the latent policy conflict that emerges when monetary policy simultaneously seeks the internal and external stability of the domestic currency; (2) strengthen political autonomy to untie potential links between monetary policy horizons and political cycles; (3) grant financial autonomy to reinforce the current de jure operational autonomy of central banks; and (4) set more rigorous accountability and transparency procedures for central banks to bolster the credibility of monetary policy.

Central banks in Central America have made important strides in modernizing monetary operations, but there is still room for improvement. While central banks established indirect instruments of monetary policy many years ago, open market operations do not allow for price discovery, as interest rates are generally determined exogenously by central banks. As a result, money markets are still shallow, whereas yield curves are rather artificial and convey meaningless information to both central banks and market participants. During recent years, central banks have not appeared to be proficient in managing liquidity surplus—stemming from an abundant international liquidity—and hence, changes in short-term central bank interest rates are not followed by similar changes in commercial bank rates.

Tracing the reaction functions of central banks in Central America allows for establishing a connection between their institutional setting and monetary policy implementation. The quantitative analysis developed in this chapter allows for verifying the main thrust of monetary policy in the sample countries, which suggests that central banks formulate and execute monetary policy in a way that is not fully consistent with the nature of the policy regime in place. In particular, it confirms that central banks, in general, behave by increasing interest rates to curtail inflationary pressures regardless of their policy regime. However, they react with different impetus, and hence, some central banks are raising interest rates less than what is required to tame inflation pressures.

A second empirical regularity is that some central banks also care about the stability of the exchange rate, which may blur their true policy objective vis-à-vis price stability. They react by adjusting interest rates upward either to prevent deviations from the targeted purchasing power parity, or to confront pressures on the exchange rate with the aim of mitigating pass-through effects of exchange rate depreciations on prices and because of the so-called “fear of floating.” By the same token, these central banks also seem to systematically resist exchange rate appreciations, which would otherwise support disinflation. In addition, central banks in Costa Rica and Guatemala exhibit a policy of accommodating inflation trends into exchange rates performance with the aim of preserving the competitiveness of their tradable activities.

The potential policy conflicts featuring central banks in Central America are probably undermining markets’ confidence in their commitment to price stability. The fact that central banks are unable to deliver a predictable monetary policy and that they at times signal mutually exclusive policy objectives may help to explain the perpetuation of an inflation bias in Central America.

While this chapter steps up the understanding of monetary policy in Central America, additional analytical work is needed to improve the effectiveness of monetary policy. Areas for further research include (1) analyzing how the transmission mechanisms of monetary policy work in the region; (2) identifying the most appropriate exchange rate regime applicable to the Central American countries, given their increasing openness and integration with the U.S. economy; and (3) defining the most suitable operational framework for monetary policy.

Appendix 6.1. Policy Reaction Function

The policy reaction function would work as follows: assume that within each operating period the central bank has a target for the interest rate, $i_{t}^{*}$ that is based on the state of the economy. Let it also be assumed that monetary authorities care about stabilizing inflation and output, so we allow for the possibility that the central bank adjusts its policy response to anticipated inflation and output. Specifically:

\begin{matrix} i_{t}^{*} = \bar{i} + β (E [π_{t + n} | Ω_{t}] - π *) + y (E [y_{t + m} | Ω_{t}] - y *), & (1) \end{matrix}

where i is the long-run equilibrium interest rate, π_t+n is the rate of inflation between periods t, t+n, y_t+m is real output between periods t and t+m, and π* and y* are the targets for inflation and output, respectively. In particular, y* is defined as the equilibrium level of output that would arise if wages and prices were perfectly flexible. Additionally, E is the expectation operator and Ω_t is the information available to the policymaker. The expression could include additional independent terms such as the exchange rate and international reserves.

To capture concerns about potentially disruptive shifts in the interest rate, it is assumed that the interest rate is adjusted only partially to its target level:

\begin{matrix} i_{t} = (1 - ρ) i_{t}^{*} + ρ_{t - 1} + ν_{t}, & (2) \end{matrix}

where the parameter ρ∈[0,1] captures the degree of interest rate smoothing. The exogenous random shock to the exchange rate, ν_t, is assumed to be i.i.d. To define an estimable equation, let $α = \bar{i} - βπ *$ and x_t=y_t–y*, then equation (2) can be written as:

\begin{matrix} i_{t}^{*} = α + β E [π_{t + n} | Ω_{t}] - π *) + γ E [x_{t + m} | Ω_{t}] . & (3) \end{matrix}

So, combining equation (4) with the partial adjustment mechanism (3) and eliminating the unobserved forecast variables yields:

\begin{matrix} i_{t} = (1 - ρ) α + (1 - ρ) {βπ}_{t + n} + (1 - ρ) γ x_{t + m} + ρ i_{t - 1} + ε_{t,} & (4) \end{matrix}

where the error term is a linear combination of the forecast errors of inflation and output, and the exogenous disturbance ν_t.

Let u_t be a vector of variables (set of instruments) within the policymaker’s information set (i.e., u_t ∈Ω_t) that are orthogonal to ∈_t. Possible elements of u_t include any lagged variables that help forecast inflation and output, as well as any contemporaneous variables that are uncorrelated with the current exchange rate shock ν_t. Thus, since E[∈_t|u_t]=0, the following equation can be estimated using the generalized method of moments (GMM) with an optimal weighting matrix:³⁹

\begin{matrix} E [i_{t} = (1 - ρ) α - (1 - ρ) {βπ}_{t + n} - (1 - ρ) γ x_{t + m} - ρ i_{t - 1} | u_{t}] = 0 & (5) \end{matrix}

Equation (5) is estimated over the sample period from 1999 to 2005 with year-on-year consumer price index (CPI) inflation, detrended output (using the Hodrick-Prescott filter) measured through the monthly index of economic activity (the so-called IMAE), and the nominal interest rate. Baseline elements of u_t are lagged values of CPI inflation, output, and the interest rate. The forward-looking horizons are varied (values n and m in the case of inflation and output, respectively) to assess the policy horizon.

Table 6A.1.

Main Provisions of Central Bank Legislation as of 2005

Sources: Central bank laws and relevant constitutional provisions.

Table 6A.1.

Main Provisions of Central Bank Legislation as of 2005

	Costa Rica	Dominican Republic	Guatemala	Honduras	Nicaragua
Policy Mandate
Central bank objective	The Central Bank of Costa Rica (CBCR) will have as its main objectives to preserve the internal and external value of the domestic currency and promote the normal functioning of the payments system.	Regulation of the monetary system, which includes the Central Bank of the Dominican Republic (CBDR) and the Superintendence of Banks, aims to maintain price stability, which is the necessary basis for the nation’s economic development.	The fundamental objective of the Bank of Guatemala (Banguat) is to help create and maintain the most favorable conditions for the orderly development of the national economy. It should promote monetary, exchange, and credit conditions conducive to price stability.	The Central Bank of Honduras (CBH) will have as an objective to preserve the internal and external value of the domestic currency and promote the normal functioning of the payments system.	The primary objective of the Central Bank of Nicaragua (CBN) is the stability of the national currency and the normal functioning of the internal and external payments.
Political Autonomy
Government body of the central bank	Board of Directors (BoD) comprises seven members, including its president, the minister of finance, and five other members.	Monetary Board (MB) comprises nine members, including the governor of the CBDR, the minister of finance, and the superintendent of banks (the last two ex-oficio members), plus another six members.	Monetary Board (MB) comprises nine members, including its president, the ministers of public finance, the economy, and agriculture, representatives of the Congress, the largest state-owned university, the banking association, and the private entrepreneurs’ association.	Board comprises five members, including its president.	Board of Directors (BoD) comprises six members, including its president, the minister of finance, and four members in consultation with the private sector, including one nominated by the largest opposition political party.
Modality of appointment of members of the government body	The BoD president is appointed by the president of the country. He also appoints the other five members, but these are ratified by Congress.	The CBDR governor and six members of the MB are directly appointed by the president of the country.	The MB president is appointed by the president of the country, whereas the other members of the MB are appointed by the institution they represent.	All five members are directly appointed by the president of the country.	The president of the country directly appoints the BoD president and four members. The latter are ratified by Congress.
Term of appointment	The BoD president is appointed to the same term as the executive branch. The other five members serve for 90 months and are appointed every 18 months, one at a time.	The governor of the CBDR and the six members of the MB are appointed for two years. The term of the ex-officio members is according to the nature of the appointment.	The term of the MB president is four years, which does not coincide with that of the president of the country. MB members appointed by the private sector and the university for a one-year renewable term.	Two members of the board serve for the same years as the president of the country and the other three are appointed on a staggered basis.	The BoD president and the representative of the opposition political party serve for the same period as the presidential term. The other three members are appointed in the middle of the presidential term.
Dismissal	While the BoD president can be freely removed by the executive branch, the five members of the BoD are removed only under legal grounds, also by the executive branch.	The CBDR governor is fired by a unanimous decision of the MB or by a three-fourths vote of the MB under given legal grounds.	The MB president is removed only upon legal grounds, but Congress has the right to dismiss him—with a qualified majority—if its annual report to Congress is not found to be satisfactory.	Members of the board are dismissed following an investigation by the executive branch on legal grounds including “lack of professional competence in conduct of their duties.”	BoD members are dismissed following an investigation by the BoD on legal grounds, including lack of professional competence in conduct of their duties. The president of the republic takes the final decision.
Economic Autonomy
Formulation and execution of monetary policy	The CBCR’s BoD is responsible for formulating and conducting monetary, exchange rate, and credit policies.	The MB is in charge of formulating monetary, exchange, and financial policies. It is responsible for approving the monetary program and monitoring its execution.	The formulation of monetary policy corresponds to the MB and the conduct of monetary policy to an Execution Committee. However, Congress has to approve Banguat paper that will be used in open market operations.	The CBH has the legal mandate to formulate and execute monetary policy.	The CBN is in charge of formulating and executing monetary policy in coordination with the government’s economic policy, but subordinating this coordination to the CBN’s observance of its primary objective.
Central bank lending to the government	The CBCR is allowed to buy treasury bills in the primary market at a market rate. The balance of treasury bills cannot exceed 1/20 of the government’s expenditure at any given time.	The CBDR cannot extend credit directly or indirectly to the government except under emergency conditions as regulated in the central bank law.	The Banguat is not allowed to provide—directly or indirectly—credit to the government (constitutional mandate).	The CBH is not allowed to provide—directly or indirectly—credit to the government. However, it can provide advances to cope with seasonal liquidity shortages. These loans are limited to 10 percent of the previous year’s tax revenue.	The CBN cannot provide credit—directly or indirectly—to the government. However, it can provide short-term advances in exchange for treasury bonds of up to 10 percent of the average tax revenues recorded in the previous two fiscal years.
Central bank role in public debt policy	The CBCR is informed about new issues of public debt.	No role.	The Banguat must issue a technical report every time the public sector issues debt.	The CBH provides a legal criterion before the government issues debt.	No role.
Lender-of-last-resort provisions (LOLR)	To safeguard financial stability, the BCCR can rediscount securities to financial institutions under specific conditions. It also provides emergency loans as defined in the law to institutions intervened by the financial authority.	The CBDR provides financial assistance to illiquid but solvent banks. The amount is capped at one and a half times the impaired bank’s equity at a 30-day maturity. Financial conditions are defined by the CBDR.	The Banguat is empowered to provide lender-of-last-resort assistance only to illiquid but solvent banks. Amount of assistance limited to 50 percent of impaired bank capital. Liquidity assistance cannot be granted more than twice a year.	The CBH can provide financial assistance to banks facing liquidity problems and in light of situations that challenge the stability of the financial system.	Lender-of-last-resort only for liquidity purposes up to 30 days maturity without a maximum limit. The CBN defines the financial conditions of such loans.
Financial Autonomy
Central bank’s capital integrity	There is no legal provision requiring the government to compensate central bank losses.	The CBDR’s losses must be compensated with Treasury bonds issued at market interest rates and at less than one-year maturity.	The Banguat must inform the Ministry of Finance should operational losses arise. The minister of finance has to incorporate these losses in the next fiscal year budget, to be covered with marketable government securities.	The CBH should register losses as receivables until agreement is achieved with the government about the mechanism and financial conditions to compensate such losses. This, in turn, has to be approved by Congress.	The government must restore the CBN’s losses by transferring securities under market conditions.
Accountability and Transparency
Accountability relative to its policy objective	The CBCR must publish its annual report within the first quarter of the year.	The CBDR governor reports annually to the executive branch and submits the CBDR annual report to Congress.	The MB president must appear before Congress twice a year to report on the policies implemented, with emphasis on the Banguat’s objectives.	The board reports once a year to Congress and twice a year to the executive branch about the outcome of its activities.	Following a constitutional mandate, the CBN governor presents an annual general report to Congress.
Disclosure of a monetary policy or inflation report	Once a year, the CBCR must disclose the monetary program, and twice a year it must publish an analysis of its execution and prospects.	The CBDR disseminates a summary of the monetary program once a year and an update on a quarterly basis.	The Banguat must publish an explanatory monetary policy report twice a year.	No specific legal provision.	No specific legal provision.
Disclosure of income statements and certification	The CBCR discloses its detailed income statements certified by the internal auditor once a year. Income statements should be certified by the CBCR’s internal auditor.	Audited income statements have to be disclosed once a year and certified by an internal auditor and also by an external audit firm.	At least once a year, the Banguat should disclose its income statement on an analytical basis. The Banguat’s accounting practices are certified by an experienced and well-known external audit firm.	The CBH publishes its financial statements immediately after the end of the fiscal year. Accounting practices and the fidelity of income statements is done by the superintendent of banks, but an external audit firm may also be hired.	The CBN discloses its financial statements monthly. At the end of the fiscal year, it discloses financial statements certified by an internationally-known external audit firm.
Disclosure of policy decisions	The CBCR should publish the BoD’s decisions on monetary policy.	Disseminates a bulletin containing the main policy/ legal decisions.	The Banguat discloses a summary of the main MB decisions.	No specific provisions.	The BoD’s decisions should be published.

Sources: Central bank laws and relevant constitutional provisions.

Table 6A.1.

Main Provisions of Central Bank Legislation as of 2005

	Costa Rica	Dominican Republic	Guatemala	Honduras	Nicaragua
Policy Mandate
Central bank objective	The Central Bank of Costa Rica (CBCR) will have as its main objectives to preserve the internal and external value of the domestic currency and promote the normal functioning of the payments system.	Regulation of the monetary system, which includes the Central Bank of the Dominican Republic (CBDR) and the Superintendence of Banks, aims to maintain price stability, which is the necessary basis for the nation’s economic development.	The fundamental objective of the Bank of Guatemala (Banguat) is to help create and maintain the most favorable conditions for the orderly development of the national economy. It should promote monetary, exchange, and credit conditions conducive to price stability.	The Central Bank of Honduras (CBH) will have as an objective to preserve the internal and external value of the domestic currency and promote the normal functioning of the payments system.	The primary objective of the Central Bank of Nicaragua (CBN) is the stability of the national currency and the normal functioning of the internal and external payments.
Political Autonomy
Government body of the central bank	Board of Directors (BoD) comprises seven members, including its president, the minister of finance, and five other members.	Monetary Board (MB) comprises nine members, including the governor of the CBDR, the minister of finance, and the superintendent of banks (the last two ex-oficio members), plus another six members.	Monetary Board (MB) comprises nine members, including its president, the ministers of public finance, the economy, and agriculture, representatives of the Congress, the largest state-owned university, the banking association, and the private entrepreneurs’ association.	Board comprises five members, including its president.	Board of Directors (BoD) comprises six members, including its president, the minister of finance, and four members in consultation with the private sector, including one nominated by the largest opposition political party.
Modality of appointment of members of the government body	The BoD president is appointed by the president of the country. He also appoints the other five members, but these are ratified by Congress.	The CBDR governor and six members of the MB are directly appointed by the president of the country.	The MB president is appointed by the president of the country, whereas the other members of the MB are appointed by the institution they represent.	All five members are directly appointed by the president of the country.	The president of the country directly appoints the BoD president and four members. The latter are ratified by Congress.
Term of appointment	The BoD president is appointed to the same term as the executive branch. The other five members serve for 90 months and are appointed every 18 months, one at a time.	The governor of the CBDR and the six members of the MB are appointed for two years. The term of the ex-officio members is according to the nature of the appointment.	The term of the MB president is four years, which does not coincide with that of the president of the country. MB members appointed by the private sector and the university for a one-year renewable term.	Two members of the board serve for the same years as the president of the country and the other three are appointed on a staggered basis.	The BoD president and the representative of the opposition political party serve for the same period as the presidential term. The other three members are appointed in the middle of the presidential term.
Dismissal	While the BoD president can be freely removed by the executive branch, the five members of the BoD are removed only under legal grounds, also by the executive branch.	The CBDR governor is fired by a unanimous decision of the MB or by a three-fourths vote of the MB under given legal grounds.	The MB president is removed only upon legal grounds, but Congress has the right to dismiss him—with a qualified majority—if its annual report to Congress is not found to be satisfactory.	Members of the board are dismissed following an investigation by the executive branch on legal grounds including “lack of professional competence in conduct of their duties.”	BoD members are dismissed following an investigation by the BoD on legal grounds, including lack of professional competence in conduct of their duties. The president of the republic takes the final decision.
Economic Autonomy
Formulation and execution of monetary policy	The CBCR’s BoD is responsible for formulating and conducting monetary, exchange rate, and credit policies.	The MB is in charge of formulating monetary, exchange, and financial policies. It is responsible for approving the monetary program and monitoring its execution.	The formulation of monetary policy corresponds to the MB and the conduct of monetary policy to an Execution Committee. However, Congress has to approve Banguat paper that will be used in open market operations.	The CBH has the legal mandate to formulate and execute monetary policy.	The CBN is in charge of formulating and executing monetary policy in coordination with the government’s economic policy, but subordinating this coordination to the CBN’s observance of its primary objective.
Central bank lending to the government	The CBCR is allowed to buy treasury bills in the primary market at a market rate. The balance of treasury bills cannot exceed 1/20 of the government’s expenditure at any given time.	The CBDR cannot extend credit directly or indirectly to the government except under emergency conditions as regulated in the central bank law.	The Banguat is not allowed to provide—directly or indirectly—credit to the government (constitutional mandate).	The CBH is not allowed to provide—directly or indirectly—credit to the government. However, it can provide advances to cope with seasonal liquidity shortages. These loans are limited to 10 percent of the previous year’s tax revenue.	The CBN cannot provide credit—directly or indirectly—to the government. However, it can provide short-term advances in exchange for treasury bonds of up to 10 percent of the average tax revenues recorded in the previous two fiscal years.
Central bank role in public debt policy	The CBCR is informed about new issues of public debt.	No role.	The Banguat must issue a technical report every time the public sector issues debt.	The CBH provides a legal criterion before the government issues debt.	No role.
Lender-of-last-resort provisions (LOLR)	To safeguard financial stability, the BCCR can rediscount securities to financial institutions under specific conditions. It also provides emergency loans as defined in the law to institutions intervened by the financial authority.	The CBDR provides financial assistance to illiquid but solvent banks. The amount is capped at one and a half times the impaired bank’s equity at a 30-day maturity. Financial conditions are defined by the CBDR.	The Banguat is empowered to provide lender-of-last-resort assistance only to illiquid but solvent banks. Amount of assistance limited to 50 percent of impaired bank capital. Liquidity assistance cannot be granted more than twice a year.	The CBH can provide financial assistance to banks facing liquidity problems and in light of situations that challenge the stability of the financial system.	Lender-of-last-resort only for liquidity purposes up to 30 days maturity without a maximum limit. The CBN defines the financial conditions of such loans.
Financial Autonomy
Central bank’s capital integrity	There is no legal provision requiring the government to compensate central bank losses.	The CBDR’s losses must be compensated with Treasury bonds issued at market interest rates and at less than one-year maturity.	The Banguat must inform the Ministry of Finance should operational losses arise. The minister of finance has to incorporate these losses in the next fiscal year budget, to be covered with marketable government securities.	The CBH should register losses as receivables until agreement is achieved with the government about the mechanism and financial conditions to compensate such losses. This, in turn, has to be approved by Congress.	The government must restore the CBN’s losses by transferring securities under market conditions.
Accountability and Transparency
Accountability relative to its policy objective	The CBCR must publish its annual report within the first quarter of the year.	The CBDR governor reports annually to the executive branch and submits the CBDR annual report to Congress.	The MB president must appear before Congress twice a year to report on the policies implemented, with emphasis on the Banguat’s objectives.	The board reports once a year to Congress and twice a year to the executive branch about the outcome of its activities.	Following a constitutional mandate, the CBN governor presents an annual general report to Congress.
Disclosure of a monetary policy or inflation report	Once a year, the CBCR must disclose the monetary program, and twice a year it must publish an analysis of its execution and prospects.	The CBDR disseminates a summary of the monetary program once a year and an update on a quarterly basis.	The Banguat must publish an explanatory monetary policy report twice a year.	No specific legal provision.	No specific legal provision.
Disclosure of income statements and certification	The CBCR discloses its detailed income statements certified by the internal auditor once a year. Income statements should be certified by the CBCR’s internal auditor.	Audited income statements have to be disclosed once a year and certified by an internal auditor and also by an external audit firm.	At least once a year, the Banguat should disclose its income statement on an analytical basis. The Banguat’s accounting practices are certified by an experienced and well-known external audit firm.	The CBH publishes its financial statements immediately after the end of the fiscal year. Accounting practices and the fidelity of income statements is done by the superintendent of banks, but an external audit firm may also be hired.	The CBN discloses its financial statements monthly. At the end of the fiscal year, it discloses financial statements certified by an internationally-known external audit firm.
Disclosure of policy decisions	The CBCR should publish the BoD’s decisions on monetary policy.	Disseminates a bulletin containing the main policy/ legal decisions.	The Banguat discloses a summary of the main MB decisions.	No specific provisions.	The BoD’s decisions should be published.

Sources: Central bank laws and relevant constitutional provisions.

Table 6A.2.

Main Features of Monetary Policy

Source: Responses to monetary policy questionnaire.

Table 6A.2.

Main Features of Monetary Policy

Key Aspects	Costa Rica	Dominican Republic	Guatemala	Honduras	Nicaragua
Monetary policy regime	Real exchange rate targeting.	Monetary targeting.	Inflation targeting.	Real exchange rate targeting.	Real exchange rate targeting.
Exchange rate system	Crawling peg according to a pre-announced daily rate of devaluation. There is no foreign currency surrender requirement but market participants must sell existing remaining surpluses to the Central bank of Costa Rica (CBCR).	Flexible exchange regime.	Flexible exchange regime.	Crawling band of 14 percent width. The slope is the difference between domestic inflation and that of its main trading partners. There is a surrender requirement of foreign currency for export earnings (except within Central America).	Crawling peg based on a monthly announcement of the rate of depreciation aimed at maintaining a purchasing power parity. There is no foreign currency surrender requirement.
	The exchange rate is determined in the interbank market based on a reference exchange rate. The latter is calculated by the CBCR from a weighted average of market transactions in t–2, adjusted by the average change in t–1.	The exchange rate is determined by market supply and demand, but the Central Bank of the Dominican Republic (CBDR) may intervene.	The exchange rate is determined by the market’s supply and demand, but the Bank of Guatemala (Banguat) intervenes to tame volatility according to a publicly known rule.	In practice, the Central Bank of Honduras (CBH) satisfies all demand of foreign exchange. Market participants make bids, taking as a reference the average exchange rate of the previous auction.	The exchange rate is determined by market supply and demand, but the Central Bank of Nicaragua (CBN) may intervene.
Financial programming	The Board of Directors (BoD) approves it every January and updates it by mid-year.	Approved annually by the Monetary Board (MB) and reviewed quarterly.	The Monetary Board (MB) approves a monetary program annually, and it is reviewed twice a year. The monetary program is not the key framework for policy formulation.	The CBH board approves the monetary program and conduct reviews on a quarterly basis.	The Board of Directors (BoD) approves it every year and conducts reviews not on a regular basis but as needed.
	The final objective is to address inflation. The intermediate targets are currency issue, money supply, and credit to the private sector.	The final objective is to address inflation. The intermediate targets are the money base and net domestic assets.	The final objective is to address inflation based on the forecasted inflation. Monetary variables are only indicative variables.	The final objective is to address inflation. The intermediate targets are CBH’s net international reserves and net domestic assets.	The final objective is to address inflation. The intermediate target is the net international reserves.
Monetary policy decision	The BoD is in charge of adopting policy decisions, particularly those relative to monetary instruments.	The Open Market Operations Committee (COMA) decides changes on monetary policy.	The MB approves the formulation of monetary policy and the Executing Committee (EC) implements it, deciding on changes in the interest rate.	While the CBH board formulates monetary policy, the Open Market Operations Committee (COMA) is the executor.	While the BoD formulates monetary policy, the Open Market Operations Committee (COMA) is the executor.
	While the BoD meets regularly every week, decisions concerning the leading rate are not adopted on a regular basis during key meetings.	The COMA meets regularly every Wednesday, but the market is not aware of those meetings. There is no specific date when the COMA reviews the stance of monetary policy.	The EC meets regularly every week (generally on Fridays). The market is aware that decisions about the policy rate are considered during the meeting after the 15th of each month.	The CBH board meets regularly each Thursday, and the COMA meets once a month. The market ignores when the CBH board will adopt a change in the policy rate.	Both the BoD and the COMA meet separately once a week. The latter assesses the financial parameters to apply in the weekly auctions. There are no specific meetings to adopt key policy decisions.
Monetary policy instruments	Reserve requirements: 15 percent on deposits in domestic and foreign currencies. Maintenance period of two weeks, with averaging provisions. Reserve requirements were changed once in 2004 (from 10 to 12 percent) and in 2005 (from 12 to 15 percent).	Reserve requirements: 20 percent for commercial banks and 15 percent for other financial institutions. Commercial banks have a daily and weekly maintenance period for domestic and foreign currencies, respectively. Other institutions have two-week and one-month maintenance periods.	Reserve requirements: 14.6 percent (0.6 percent remunerated) on deposits in domestic and foreign currency. The maintenance period is one month, with averaging provisions. Reserve requirements have not been modified since 1999.	Reserve requirements: 12 percent in domestic and foreign currencies. Maintenance period of 14 days, with averaging provisions. There is also a mandatory 2 percent remunerated investment at the CBH. In foreign currency there is another 38 percent requirement to be held in overseas.	Reserve requirements: 16.25 percent on deposits in domestic and foreign currencies. Maintenance period of one week without compensation within the period.
	Two modalities of open market operations: (1) Short-term investments in the CBCR at 7, 15, and 30 days; and (2) auctions of CBCR’s zero-coupon securities (at 3, 6, 9, and 12 months) and coupon securities (at 2, 3, 5, and 7 years). Only banks and brokerage houses are authorized to participate in the auctions.	Open market operations are held weekly under multiple-price auctions of “certificates of participation,” zero coupon, and long-term securities at 35, 91, 182, and 364 days. All economic agents can participate. The CBDR also offers short- and long-term deposit facilities that pay rates consistent with those resulting from the auctions.	The Banguat conducts open market operations at 7, 91, and 182 days, and at 1, 2, 4, 6, and 8 years. Only financial institutions participate. It also conducts auctions of time deposits at same maturities (except seven-day) in domestic and foreign currencies. All economic agents participate in the latter via brokerage houses.	The CBH conducts open market operations in domestic currency and a limited amount in foreign currency. It holds weekly auctions (at seven days) and bi-weekly auctions (at 90, 180, and 360 days). While in the former only financial institutions participate, the latter is open to other market participants.	The CBN calls for auctions once a week and offers securities at three-month and one-year maturities. Only banks can participate.
Liquidity management	The CBCR conducts liquidity forecasting every two weeks based on its financial programming. This is the basis for defining the absorption needed to observe monetary targets envisaged in the financial programming.	The CBDR conducts weekly liquidity forecasting based on the financial programming.	The Banguat conducts liquidity forecasting on a daily basis. The EC uses this information to plan weekly open market operations.	The CBH conducts weekly liquidity forecasting for each working day. It serves to define the amounts to be issued in open market operations.	The CBN carries out monthly liquidity forecasting on the basis of the financial programming after adjusting for seasonal trends.
	The CBCR uses its deposit facilities (at 7, 15, and 30 days) to drain liquidity. Most deposits concentrate on 30-day maturity. Interest rates are directly fixed by the CBCR.	The CBDR manages liquidity through the weekly open market operations.	The auctions at seven-day maturity are aimed at managing short-term liquidity.	The CBH uses the weekly auctions to handle short-term liquidity and biweekly auctions to manage structural liquidity.	The CBN plans and executes open market operations with the aim of observing its international reserves target in line with its monetary program.
	There is a shallow interbank market for overnight transactions of government and central bank securities.	There is a shallow interbank market based on certificates of deposit, which do not require pledging collateral.	There is an interbank market, mainly repo operations conducted through the stock exchange.	There are only limited transactions, which do not use collateral, as CBH and government securities are non-negotiable.	There is an interbank market. However, the CBN is in the process of ascertaining how significant this market is.
	The CBCR conducts overnight repo operations but no reverse repo transactions.	The CBDR does not conduct repo operations.	The Banguat holds repo transactions at seven-day intervals using government and its own securities as collateral.	The CBH does not conduct repo operations.	The CBN does not conduct repo operations at any maturity.
Policy signaling	The CBCR defines the 30-day interest rate paid in its deposit facility as its policy rate. This rate is not market-determined.	There is no specific policy signaling. Markets ascertain the CBDR’s policy stance depending on its weekly open market operations.	The Banguat uses the seven-day interest rate as a policy rate. The EC adjusts this rate with the explicit intention of signaling Banguat’s policy stance.	The CBH uses as a policy rate the seven-day interest rates resulting from the weekly auctions.	There is no specific policy signaling. Markets ascertain CBN’s policy stance depending on the volume of weekly open market operations.
Standing facilities	The CBCR has not established daily standing facilities.	The CBDR has established standing facilities at up to seven days’ maturity. The COMA sets interest rates and banks pledge the CBDR’s paper as collateral in the credit facility.	There are no standing facilities available.	The CBH offers overnight deposit and credit facilities (pledging CBH’s securities as collateral). As of end-2005, interest rates were +/– 4 percent of the policy rate, respectively.	There is only an overnight credit facility to be used at most four times a month, with at least two days in between. Banks pledge commercial paper as collateral at market rates.
Accountability and transparency	There is no specific legal provision for appearances before Congress by the CBCR governor.	The CBDR governor reports annually to the executive branch and submits the CBDR’s annual report to Congress.	The Banguat president appears before Congress twice a year (January and July) to report on Banguat’s policies.	The CBH board reports once a year to the legislative and twice a year to the executive branch.	The CBN governor reports annually to the president of the country. There is no legal provision for his appearance before Congress.
	The CBCR disseminates an inflation report twice a year. It also releases an economic report monthly and biannually.	The CBDR develops and disseminates a monetary policy report. It also releases a quarterly economic report.	The Banguat prepares and disseminates a monetary policy report twice a year.	The CBH does not prepare an inflation report but it develops a quarterly report about major developments of the Honduran economy.	The CBN releases a report on a quarterly basis—with a six- to eight-week lag—monitoring the monetary program.
	The CBCR publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The CBDR publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The Banguat discloses the minutes underlying the decisions adopted by the EC.	The CBH publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The CBN publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.

Source: Responses to monetary policy questionnaire.

Table 6A.2.

Main Features of Monetary Policy

Key Aspects	Costa Rica	Dominican Republic	Guatemala	Honduras	Nicaragua
Monetary policy regime	Real exchange rate targeting.	Monetary targeting.	Inflation targeting.	Real exchange rate targeting.	Real exchange rate targeting.
Exchange rate system	Crawling peg according to a pre-announced daily rate of devaluation. There is no foreign currency surrender requirement but market participants must sell existing remaining surpluses to the Central bank of Costa Rica (CBCR).	Flexible exchange regime.	Flexible exchange regime.	Crawling band of 14 percent width. The slope is the difference between domestic inflation and that of its main trading partners. There is a surrender requirement of foreign currency for export earnings (except within Central America).	Crawling peg based on a monthly announcement of the rate of depreciation aimed at maintaining a purchasing power parity. There is no foreign currency surrender requirement.
	The exchange rate is determined in the interbank market based on a reference exchange rate. The latter is calculated by the CBCR from a weighted average of market transactions in t–2, adjusted by the average change in t–1.	The exchange rate is determined by market supply and demand, but the Central Bank of the Dominican Republic (CBDR) may intervene.	The exchange rate is determined by the market’s supply and demand, but the Bank of Guatemala (Banguat) intervenes to tame volatility according to a publicly known rule.	In practice, the Central Bank of Honduras (CBH) satisfies all demand of foreign exchange. Market participants make bids, taking as a reference the average exchange rate of the previous auction.	The exchange rate is determined by market supply and demand, but the Central Bank of Nicaragua (CBN) may intervene.
Financial programming	The Board of Directors (BoD) approves it every January and updates it by mid-year.	Approved annually by the Monetary Board (MB) and reviewed quarterly.	The Monetary Board (MB) approves a monetary program annually, and it is reviewed twice a year. The monetary program is not the key framework for policy formulation.	The CBH board approves the monetary program and conduct reviews on a quarterly basis.	The Board of Directors (BoD) approves it every year and conducts reviews not on a regular basis but as needed.
	The final objective is to address inflation. The intermediate targets are currency issue, money supply, and credit to the private sector.	The final objective is to address inflation. The intermediate targets are the money base and net domestic assets.	The final objective is to address inflation based on the forecasted inflation. Monetary variables are only indicative variables.	The final objective is to address inflation. The intermediate targets are CBH’s net international reserves and net domestic assets.	The final objective is to address inflation. The intermediate target is the net international reserves.
Monetary policy decision	The BoD is in charge of adopting policy decisions, particularly those relative to monetary instruments.	The Open Market Operations Committee (COMA) decides changes on monetary policy.	The MB approves the formulation of monetary policy and the Executing Committee (EC) implements it, deciding on changes in the interest rate.	While the CBH board formulates monetary policy, the Open Market Operations Committee (COMA) is the executor.	While the BoD formulates monetary policy, the Open Market Operations Committee (COMA) is the executor.
	While the BoD meets regularly every week, decisions concerning the leading rate are not adopted on a regular basis during key meetings.	The COMA meets regularly every Wednesday, but the market is not aware of those meetings. There is no specific date when the COMA reviews the stance of monetary policy.	The EC meets regularly every week (generally on Fridays). The market is aware that decisions about the policy rate are considered during the meeting after the 15th of each month.	The CBH board meets regularly each Thursday, and the COMA meets once a month. The market ignores when the CBH board will adopt a change in the policy rate.	Both the BoD and the COMA meet separately once a week. The latter assesses the financial parameters to apply in the weekly auctions. There are no specific meetings to adopt key policy decisions.
Monetary policy instruments	Reserve requirements: 15 percent on deposits in domestic and foreign currencies. Maintenance period of two weeks, with averaging provisions. Reserve requirements were changed once in 2004 (from 10 to 12 percent) and in 2005 (from 12 to 15 percent).	Reserve requirements: 20 percent for commercial banks and 15 percent for other financial institutions. Commercial banks have a daily and weekly maintenance period for domestic and foreign currencies, respectively. Other institutions have two-week and one-month maintenance periods.	Reserve requirements: 14.6 percent (0.6 percent remunerated) on deposits in domestic and foreign currency. The maintenance period is one month, with averaging provisions. Reserve requirements have not been modified since 1999.	Reserve requirements: 12 percent in domestic and foreign currencies. Maintenance period of 14 days, with averaging provisions. There is also a mandatory 2 percent remunerated investment at the CBH. In foreign currency there is another 38 percent requirement to be held in overseas.	Reserve requirements: 16.25 percent on deposits in domestic and foreign currencies. Maintenance period of one week without compensation within the period.
	Two modalities of open market operations: (1) Short-term investments in the CBCR at 7, 15, and 30 days; and (2) auctions of CBCR’s zero-coupon securities (at 3, 6, 9, and 12 months) and coupon securities (at 2, 3, 5, and 7 years). Only banks and brokerage houses are authorized to participate in the auctions.	Open market operations are held weekly under multiple-price auctions of “certificates of participation,” zero coupon, and long-term securities at 35, 91, 182, and 364 days. All economic agents can participate. The CBDR also offers short- and long-term deposit facilities that pay rates consistent with those resulting from the auctions.	The Banguat conducts open market operations at 7, 91, and 182 days, and at 1, 2, 4, 6, and 8 years. Only financial institutions participate. It also conducts auctions of time deposits at same maturities (except seven-day) in domestic and foreign currencies. All economic agents participate in the latter via brokerage houses.	The CBH conducts open market operations in domestic currency and a limited amount in foreign currency. It holds weekly auctions (at seven days) and bi-weekly auctions (at 90, 180, and 360 days). While in the former only financial institutions participate, the latter is open to other market participants.	The CBN calls for auctions once a week and offers securities at three-month and one-year maturities. Only banks can participate.
Liquidity management	The CBCR conducts liquidity forecasting every two weeks based on its financial programming. This is the basis for defining the absorption needed to observe monetary targets envisaged in the financial programming.	The CBDR conducts weekly liquidity forecasting based on the financial programming.	The Banguat conducts liquidity forecasting on a daily basis. The EC uses this information to plan weekly open market operations.	The CBH conducts weekly liquidity forecasting for each working day. It serves to define the amounts to be issued in open market operations.	The CBN carries out monthly liquidity forecasting on the basis of the financial programming after adjusting for seasonal trends.
	The CBCR uses its deposit facilities (at 7, 15, and 30 days) to drain liquidity. Most deposits concentrate on 30-day maturity. Interest rates are directly fixed by the CBCR.	The CBDR manages liquidity through the weekly open market operations.	The auctions at seven-day maturity are aimed at managing short-term liquidity.	The CBH uses the weekly auctions to handle short-term liquidity and biweekly auctions to manage structural liquidity.	The CBN plans and executes open market operations with the aim of observing its international reserves target in line with its monetary program.
	There is a shallow interbank market for overnight transactions of government and central bank securities.	There is a shallow interbank market based on certificates of deposit, which do not require pledging collateral.	There is an interbank market, mainly repo operations conducted through the stock exchange.	There are only limited transactions, which do not use collateral, as CBH and government securities are non-negotiable.	There is an interbank market. However, the CBN is in the process of ascertaining how significant this market is.
	The CBCR conducts overnight repo operations but no reverse repo transactions.	The CBDR does not conduct repo operations.	The Banguat holds repo transactions at seven-day intervals using government and its own securities as collateral.	The CBH does not conduct repo operations.	The CBN does not conduct repo operations at any maturity.
Policy signaling	The CBCR defines the 30-day interest rate paid in its deposit facility as its policy rate. This rate is not market-determined.	There is no specific policy signaling. Markets ascertain the CBDR’s policy stance depending on its weekly open market operations.	The Banguat uses the seven-day interest rate as a policy rate. The EC adjusts this rate with the explicit intention of signaling Banguat’s policy stance.	The CBH uses as a policy rate the seven-day interest rates resulting from the weekly auctions.	There is no specific policy signaling. Markets ascertain CBN’s policy stance depending on the volume of weekly open market operations.
Standing facilities	The CBCR has not established daily standing facilities.	The CBDR has established standing facilities at up to seven days’ maturity. The COMA sets interest rates and banks pledge the CBDR’s paper as collateral in the credit facility.	There are no standing facilities available.	The CBH offers overnight deposit and credit facilities (pledging CBH’s securities as collateral). As of end-2005, interest rates were +/– 4 percent of the policy rate, respectively.	There is only an overnight credit facility to be used at most four times a month, with at least two days in between. Banks pledge commercial paper as collateral at market rates.
Accountability and transparency	There is no specific legal provision for appearances before Congress by the CBCR governor.	The CBDR governor reports annually to the executive branch and submits the CBDR’s annual report to Congress.	The Banguat president appears before Congress twice a year (January and July) to report on Banguat’s policies.	The CBH board reports once a year to the legislative and twice a year to the executive branch.	The CBN governor reports annually to the president of the country. There is no legal provision for his appearance before Congress.
	The CBCR disseminates an inflation report twice a year. It also releases an economic report monthly and biannually.	The CBDR develops and disseminates a monetary policy report. It also releases a quarterly economic report.	The Banguat prepares and disseminates a monetary policy report twice a year.	The CBH does not prepare an inflation report but it develops a quarterly report about major developments of the Honduran economy.	The CBN releases a report on a quarterly basis—with a six- to eight-week lag—monitoring the monetary program.
	The CBCR publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The CBDR publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The Banguat discloses the minutes underlying the decisions adopted by the EC.	The CBH publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The CBN publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.

Source: Responses to monetary policy questionnaire.

References

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International Monetary Fund, 2005, Annual Report on Exchange Arrangements and Exchange Restrictions (Washington).
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International Monetary Fund, 2006, “Developments in Domestic Fuel Prices, Taxes, and Subsidies in Selected Countries,” Fiscal Affairs Department (unpublished; Washington: International Monetary Fund).
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Jácome H., Luis I., and Francisco Vázquez, 2005, “Any Link Between Legal Central Bank Independence and Inflation? Evidence from Latin America and the Caribbean,” IMF Working Paper 05/75 (Washington: International Monetary Fund).
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Kim, Jun, and Laura Papi, 2005, “Regional Integration and Exchange Rate Arrangements,” in Central America: Global Integration and Regional Cooperation, IMF Occasional Paper 243, ed. by Marcus Rodlauer and Alfred Schipke (Washington: International Monetary Fund).
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Lybek, Tony, 1998, “Elements of Central Bank: Autonomy and Accountability,” Monetary and Exchange Affairs Department Operational Paper 98/1 (Washington: International Monetary Fund).
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McCallum, Bennett, 1988, “Robustness Properties of a Rule for Monetary Policy,” Carnegie-Rochester Conference Series on Public Society, Vol. 29, pp. 173–204.
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Papaioannou, Michael G., 2003, “Determinants of the Choice of Exchange Rate Regimes in Six Central American Countries: An Empirical Analysis,” IMF Working Paper 03/59 (Washington: International Monetary Fund).
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Parrado, Eric, 2004, “Singapore’s Unique Monetary Policy: How Does it Work?” IMF Working Paper 04/10 (Washington: International Monetary Fund).
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Rennhack, Robert, and Erik Offerdal, 2004, The Macro-economy of Central America (Washington: International Monetary Fund).
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Eric Parrado is affiliated with the Central Bank of Chile.

“Central America” is this chapter refers to Costa Rica, Guatemala, Honduras, Nicaragua, and the Dominican Republic. References to El Salvador and Panama are occasionally made for comparative purposes.

An analysis of exchange rate policies was already developed by Kim and Papi (2005) and Papaioannou (2003).

See recent regional analyses such as Rennhack and Offerdal (2004) and Rodlauer and Schipke (2005), which focus on macroeconomic, structural reform, and integration issues, but do not address monetary policy.

Even El Salvador reformed its central bank law in 1991, well before adopting the U.S. dollar as its legal tender in 2001.

However, Central American central banks are by law more independent than central banks in the Caribbean, as reported in Jácome and Vázquez (2005).

“Autonomy” and “independence” are used interchangeably in this chapter, although they may have slightly different meanings. See Lybek (1998).

The objective of the Monetary Board of the Bank of Guatemala is defined in the 1986 Constitution (Article 133). However, the 2002 Organic Law of the Bank of Guatemala establishes that its fundamental objective is “to contribute to create and preserve the most favorable conditions for an orderly development of the national economy and, to this end, it will favor the monetary, exchange rate, credit conditions that promote price stability.” Given that the Monetary Board is by constitutional mandate in charge of determining monetary, exchange rate, and credit policies, its objective unambiguously prevails over that of the Bank of Guatemala.

Moreover, in Guatemala, congress has the right to dismiss the governor of the central bank—with a qualified majority—if its annual report to congress is not found to be satisfactory.

The same happens in Nicaragua, since the president appoints the members of the central bank board in consultation with the private sector.

Financial weakness is exacerbated in Honduras because the central bank budget has to be approved by congress. Guatemala also faces a potential restriction to maintaining operational autonomy, as congress has to authorize the issuance of central bank stabilization bonds, which, however, are not currently used for open market operations.

To avoid extending a blank check from the government to the central bank, the latter should foster governance policies to make its operational expenses transparent, particularly the aggregate wage bill and other administrative outlays.

A detailed specification of this index and its difference from the Cukierman index is found in Jácome and Vázquez (2005).

The slight deterioration in the autonomy of the Central Bank of Honduras following the 2000 reform is because today, the executive branch has some more leeway than before to remove members of the central bank board of directors.

In practice, this distortion is less of a problem when countries have in place a flexible exchange rate, as in Mexico, although the central bank still has no practical autonomy for maintaining a policy for the accumulation of international reserves.

This outcome is consistent with the result obtained in the empirical analysis conducted by Jácome and Vázquez (2005) for Latin America and the Caribbean.

In particular, the Central American countries rank above Chile, Peru, Colombia, Bolivia, and Mexico, with the Dominican Republic behaving as an outlier as a result of the effects of the 2003 systemic banking crisis.

Besides the Central American countries, the figures include observations for all Latin American countries in South America (except for Ecuador) plus Mexico.

The thrust of the argument prevails when we exclude the Dominican Republic from the figures, which is explained, in part, because central banks in countries like Colombia, Mexico, Chile in 2004, and Peru in 2005, continued making progress in abating inflation despite the adverse effects of the oil shock.

According to the IMF (2006), the pass-through to domestic gasoline prices during 2003–05 in Chile, Colombia, and Peru was higher than in all the countries in our sample, except for the Dominican Republic.

In particular, in Honduras and Nicaragua, the sum of exports and imports of goods—including net exports from maquilas—exceed 80 percent of GDP, with more than half of exports sold to the United States.

Financial dollarization—defined as foreign currency deposits over total deposits, not including offshore institutions—is particularly noticeable in Nicaragua (close to 70 percent), Costa Rica (more than 55 percent, and 75 percent when the offshore is included), and Honduras (nearly 40 percent), as of end-2005.

Recently, Honduras has been classified as featuring a fixed exchange regime because the lower end of the band became a horizontal line.

During 2004 the exchange rate appreciation trend in Guatemala—associated with a surge in capital inflows—was coupled with a more than 20 percent increase in international reserves. The Bank of Guatemala’s intervention in the foreign currency market explains a significant portion of this increase.

For example, capital mobility is hindered in Honduras because of the restrictive effects imposed by the mandatory surrender requirement of foreign currency to the central bank, whereas in Costa Rica commercial banks are unable to increase their net foreign exchange position in excess of 0.5 percent per day.

Moreover, a significant component of capital inflows to Central America stems from workers’ remittances in the United States, which are inelastic to changes in the domestic interest rate.

The disclosure of an inflation report and the publication of the minutes of the monetary policy committee meetings are two important landmarks that strengthen the transparency of monetary policy in Guatemala.

There are also other practices that potentially hinder the effectiveness of monetary policy. For instance, in the Dominican Republic, the central bank focuses simultaneously on managing domestic debt, which at times is not consistent with the achievement of monetary policy goals. Another example is that of the Central Bank of Costa Rica, which conducts simultaneous auctions of government paper and its own securities (with equal maturities), and defines a single cut-off rate together with the treasury. If the central bank needs to tighten monetary policy a conflict of objectives emerges because the government generally prefers lower rather than higher interest rates to minimize the cost of servicing the current large sovereign debt.

In Central America, central bank deficits are as high as more than 1 percent of GDP in most countries. As central banks’ operating losses become an ongoing distortion, markets may have doubts about the long-term ability of the banks to preserve price stability.

Guatemala and Honduras chose the seven-day central bank interest rate, whereas Costa Rica initially selected the 30-day interest rate and later the overnight rate paid in the central bank deposit facility.

Corbo (2002) finds that, in setting their policy rates, central banks consider not only inflation but also other objectives such as output and the exchange rate.

See Appendix 6.1 for further details.

In particular, the Monetary Authority of Singapore explicitly uses a trade-weighted index to conduct monetary policy and offset fluctuations both in inflation and output. See Parrado (2004).

The data for the Dominican Republic was collected on a quarterly basis because this country lacks a monthly measure of economic activity.

While the Bank of Guatemala claims to have gradually started the transition to inflation targeting in 2000, we chose to artificially divide the two periods in connection with a large sovereign debt placement that took place in late 2001, and which produced a once-and-for-all 50 percent increase in international reserves, and hence a structural break in the series.

Even at a conceptual level, the impact of changes in the rate of crawl on inflation and output volatility is unclear and depends on the characteristics of the monetary transmission channels. Should the interest rate effect dominate the exchange rate effect, at least in the short run, a demand shock may need to be met by an increase in the rate of crawl (that allows for a rise in interest rates). A reduction in the rate of crawl would otherwise be appropriate.

The real exchange rate is lagged in order to avoid collinearity with the nominal exchange rate. A one-month lag reflects the delay in the availability of this information in the Central American central banks.

Other than this, in both countries capital inflows are less responsive to changes in the interest rate as they are large net recipients of foreign exchange from workers’ remittances and foreign aid.

The use of an optimal weighting matrix implies that GMM estimates are robust to heteroscedasticity and autocorrelation of unknown form. It is worth noting that the GMM technique requires no information about the exact distribution of the error term, which, in general, is assumed to be drawn from a normal distribution.

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Table 6A.2.

Main Features of Monetary Policy

Key Aspects	Costa Rica	Dominican Republic	Guatemala	Honduras	Nicaragua
Monetary policy regime	Real exchange rate targeting.	Monetary targeting.	Inflation targeting.	Real exchange rate targeting.	Real exchange rate targeting.
Exchange rate system	Crawling peg according to a pre-announced daily rate of devaluation. There is no foreign currency surrender requirement but market participants must sell existing remaining surpluses to the Central bank of Costa Rica (CBCR).	Flexible exchange regime.	Flexible exchange regime.	Crawling band of 14 percent width. The slope is the difference between domestic inflation and that of its main trading partners. There is a surrender requirement of foreign currency for export earnings (except within Central America).	Crawling peg based on a monthly announcement of the rate of depreciation aimed at maintaining a purchasing power parity. There is no foreign currency surrender requirement.
	The exchange rate is determined in the interbank market based on a reference exchange rate. The latter is calculated by the CBCR from a weighted average of market transactions in t–2, adjusted by the average change in t–1.	The exchange rate is determined by market supply and demand, but the Central Bank of the Dominican Republic (CBDR) may intervene.	The exchange rate is determined by the market’s supply and demand, but the Bank of Guatemala (Banguat) intervenes to tame volatility according to a publicly known rule.	In practice, the Central Bank of Honduras (CBH) satisfies all demand of foreign exchange. Market participants make bids, taking as a reference the average exchange rate of the previous auction.	The exchange rate is determined by market supply and demand, but the Central Bank of Nicaragua (CBN) may intervene.
Financial programming	The Board of Directors (BoD) approves it every January and updates it by mid-year.	Approved annually by the Monetary Board (MB) and reviewed quarterly.	The Monetary Board (MB) approves a monetary program annually, and it is reviewed twice a year. The monetary program is not the key framework for policy formulation.	The CBH board approves the monetary program and conduct reviews on a quarterly basis.	The Board of Directors (BoD) approves it every year and conducts reviews not on a regular basis but as needed.
	The final objective is to address inflation. The intermediate targets are currency issue, money supply, and credit to the private sector.	The final objective is to address inflation. The intermediate targets are the money base and net domestic assets.	The final objective is to address inflation based on the forecasted inflation. Monetary variables are only indicative variables.	The final objective is to address inflation. The intermediate targets are CBH’s net international reserves and net domestic assets.	The final objective is to address inflation. The intermediate target is the net international reserves.
Monetary policy decision	The BoD is in charge of adopting policy decisions, particularly those relative to monetary instruments.	The Open Market Operations Committee (COMA) decides changes on monetary policy.	The MB approves the formulation of monetary policy and the Executing Committee (EC) implements it, deciding on changes in the interest rate.	While the CBH board formulates monetary policy, the Open Market Operations Committee (COMA) is the executor.	While the BoD formulates monetary policy, the Open Market Operations Committee (COMA) is the executor.
	While the BoD meets regularly every week, decisions concerning the leading rate are not adopted on a regular basis during key meetings.	The COMA meets regularly every Wednesday, but the market is not aware of those meetings. There is no specific date when the COMA reviews the stance of monetary policy.	The EC meets regularly every week (generally on Fridays). The market is aware that decisions about the policy rate are considered during the meeting after the 15th of each month.	The CBH board meets regularly each Thursday, and the COMA meets once a month. The market ignores when the CBH board will adopt a change in the policy rate.	Both the BoD and the COMA meet separately once a week. The latter assesses the financial parameters to apply in the weekly auctions. There are no specific meetings to adopt key policy decisions.
Monetary policy instruments	Reserve requirements: 15 percent on deposits in domestic and foreign currencies. Maintenance period of two weeks, with averaging provisions. Reserve requirements were changed once in 2004 (from 10 to 12 percent) and in 2005 (from 12 to 15 percent).	Reserve requirements: 20 percent for commercial banks and 15 percent for other financial institutions. Commercial banks have a daily and weekly maintenance period for domestic and foreign currencies, respectively. Other institutions have two-week and one-month maintenance periods.	Reserve requirements: 14.6 percent (0.6 percent remunerated) on deposits in domestic and foreign currency. The maintenance period is one month, with averaging provisions. Reserve requirements have not been modified since 1999.	Reserve requirements: 12 percent in domestic and foreign currencies. Maintenance period of 14 days, with averaging provisions. There is also a mandatory 2 percent remunerated investment at the CBH. In foreign currency there is another 38 percent requirement to be held in overseas.	Reserve requirements: 16.25 percent on deposits in domestic and foreign currencies. Maintenance period of one week without compensation within the period.
	Two modalities of open market operations: (1) Short-term investments in the CBCR at 7, 15, and 30 days; and (2) auctions of CBCR’s zero-coupon securities (at 3, 6, 9, and 12 months) and coupon securities (at 2, 3, 5, and 7 years). Only banks and brokerage houses are authorized to participate in the auctions.	Open market operations are held weekly under multiple-price auctions of “certificates of participation,” zero coupon, and long-term securities at 35, 91, 182, and 364 days. All economic agents can participate. The CBDR also offers short- and long-term deposit facilities that pay rates consistent with those resulting from the auctions.	The Banguat conducts open market operations at 7, 91, and 182 days, and at 1, 2, 4, 6, and 8 years. Only financial institutions participate. It also conducts auctions of time deposits at same maturities (except seven-day) in domestic and foreign currencies. All economic agents participate in the latter via brokerage houses.	The CBH conducts open market operations in domestic currency and a limited amount in foreign currency. It holds weekly auctions (at seven days) and bi-weekly auctions (at 90, 180, and 360 days). While in the former only financial institutions participate, the latter is open to other market participants.	The CBN calls for auctions once a week and offers securities at three-month and one-year maturities. Only banks can participate.
Liquidity management	The CBCR conducts liquidity forecasting every two weeks based on its financial programming. This is the basis for defining the absorption needed to observe monetary targets envisaged in the financial programming.	The CBDR conducts weekly liquidity forecasting based on the financial programming.	The Banguat conducts liquidity forecasting on a daily basis. The EC uses this information to plan weekly open market operations.	The CBH conducts weekly liquidity forecasting for each working day. It serves to define the amounts to be issued in open market operations.	The CBN carries out monthly liquidity forecasting on the basis of the financial programming after adjusting for seasonal trends.
	The CBCR uses its deposit facilities (at 7, 15, and 30 days) to drain liquidity. Most deposits concentrate on 30-day maturity. Interest rates are directly fixed by the CBCR.	The CBDR manages liquidity through the weekly open market operations.	The auctions at seven-day maturity are aimed at managing short-term liquidity.	The CBH uses the weekly auctions to handle short-term liquidity and biweekly auctions to manage structural liquidity.	The CBN plans and executes open market operations with the aim of observing its international reserves target in line with its monetary program.
	There is a shallow interbank market for overnight transactions of government and central bank securities.	There is a shallow interbank market based on certificates of deposit, which do not require pledging collateral.	There is an interbank market, mainly repo operations conducted through the stock exchange.	There are only limited transactions, which do not use collateral, as CBH and government securities are non-negotiable.	There is an interbank market. However, the CBN is in the process of ascertaining how significant this market is.
	The CBCR conducts overnight repo operations but no reverse repo transactions.	The CBDR does not conduct repo operations.	The Banguat holds repo transactions at seven-day intervals using government and its own securities as collateral.	The CBH does not conduct repo operations.	The CBN does not conduct repo operations at any maturity.
Policy signaling	The CBCR defines the 30-day interest rate paid in its deposit facility as its policy rate. This rate is not market-determined.	There is no specific policy signaling. Markets ascertain the CBDR’s policy stance depending on its weekly open market operations.	The Banguat uses the seven-day interest rate as a policy rate. The EC adjusts this rate with the explicit intention of signaling Banguat’s policy stance.	The CBH uses as a policy rate the seven-day interest rates resulting from the weekly auctions.	There is no specific policy signaling. Markets ascertain CBN’s policy stance depending on the volume of weekly open market operations.
Standing facilities	The CBCR has not established daily standing facilities.	The CBDR has established standing facilities at up to seven days’ maturity. The COMA sets interest rates and banks pledge the CBDR’s paper as collateral in the credit facility.	There are no standing facilities available.	The CBH offers overnight deposit and credit facilities (pledging CBH’s securities as collateral). As of end-2005, interest rates were +/– 4 percent of the policy rate, respectively.	There is only an overnight credit facility to be used at most four times a month, with at least two days in between. Banks pledge commercial paper as collateral at market rates.
Accountability and transparency	There is no specific legal provision for appearances before Congress by the CBCR governor.	The CBDR governor reports annually to the executive branch and submits the CBDR’s annual report to Congress.	The Banguat president appears before Congress twice a year (January and July) to report on Banguat’s policies.	The CBH board reports once a year to the legislative and twice a year to the executive branch.	The CBN governor reports annually to the president of the country. There is no legal provision for his appearance before Congress.
	The CBCR disseminates an inflation report twice a year. It also releases an economic report monthly and biannually.	The CBDR develops and disseminates a monetary policy report. It also releases a quarterly economic report.	The Banguat prepares and disseminates a monetary policy report twice a year.	The CBH does not prepare an inflation report but it develops a quarterly report about major developments of the Honduran economy.	The CBN releases a report on a quarterly basis—with a six- to eight-week lag—monitoring the monetary program.
	The CBCR publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The CBDR publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The Banguat discloses the minutes underlying the decisions adopted by the EC.	The CBH publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.	The CBN publishes the decisions adopted concerning monetary policy, but not the minutes of the discussions behind such policy decisions.

Source: Responses to monetary policy questionnaire.

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Abstract

Institutional Framework for Monetary Policy

Central Bank Reform

Measuring Central Bank Independence

Central Bank Reform and Inflation

A Snapshot of Monetary Policy Formulation and Execution

Recent Trends in Policy Formulation

Modernization of the Operational Framework

Empirical Regularities Supporting the Characterization of Monetary Policy

Methodology

Data

Estimations

Interest Rate Reaction Functions

Exchange Rate Crawl Reaction Function

Money-Base Reaction Function

Conclusions

Appendix 6.1. Policy Reaction Function

References

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