Lessons from 25 years of the Bank of Mexico's independence

Speech by Mr Agustín Carstens, General Manager of the BIS, at the celebration of 25 years of Bank of Mexico independence, Mexico City, 22 November 2019.

I. Introduction

I would like to begin by warmly congratulating the Bank of Mexico on its first 25 years of independence. But I would like to go further. The celebration should not be limited to the anniversary itself, but should also include all those years of continuous, effective, responsible and successful exercise of autonomy.

During that time, the Bank has acted conscientiously, having implemented a monetary policy geared towards achieving the primary mandate established for it by the Constitution:¹ ensuring low and stable inflation. Moreover, the policy measures taken by the Bank have always been in line with the key limitation the Constitution sets for it, in the sense that it cannot extend inflationary financing to the federal government.

The results have been plain to see. In the years since the central bank's autonomy came into effect in 1994, inflation in Mexico has been reduced significantly, as have its volatility and persistence. These achievements, together with a well communicated monetary policy, have led to an effective anchoring of inflation expectations at levels close to the target level determined by the Bank, which has in turn been reflected in lower real and nominal medium- and long-term interest rates. This has surely made the country more efficient, as less uncertainty about inflation makes the signals from relative price adjustments much clearer. This facilitates better allocation of scarce resources among different uses and over time.

This favours more and better-quality saving, spurring investment and the consumption of durable goods. The end result has been higher - albeit insufficient - economic growth, job creation, the reduction of extreme poverty and better income distribution.

For these reasons, it is said that maintaining low and stable inflation is not an end in itself, but a means to achieving higher goals in terms of public welfare. This highlights the importance of the Bank of Mexico's independence and its responsible implementation.

That said, what makes a central bank's independence work? There are four relevant dimensions: legal, economic, social and political. In principle, they should support each other and interact in a virtuous way to produce the desired results. We can glean lessons from the Bank of Mexico's experience that shed light on the way this virtuous process occurs. In the rest of my speech, I will set forth four central lessons which I personally have identified.

II. Four lessons from 25 years of central bank independence

One. Effective independence requires extensive social and political support.  

Central bank autonomy is, first and foremost, a political phenomenon, in addition to offering a technical solution to the problem of how to efficiently achieve low and stable inflation. That the creation of a state institution committed to preserving the domestic currency's purchasing power is enshrined in the constitution is a categorical political expression by society as a whole, which reflects the importance of protecting it from the painful effects of disorderly inflation. This expression is underpinned by the collective memory of the distress experienced in times of high inflation, fiscal disorder and financial instability. We must remember that, among other ramifications, inflation is a highly regressive tax, as it affects most those who have the least.

One might think that the societal conviction that uncontrolled inflation is undesirable is very strong, deeply rooted and unlikely to change. But we should not be so sure. The central bank could fall victim to its own success. Instilling that conviction in subsequent generations is a great challenge. Around 35% of the Mexican population has never lived through times of high inflation.

So, it is essential that the Bank of Mexico not flag in its efforts to remind the population, in particular the younger generations, about the benefits of an economy free from inflationary problems. Nurturing that conviction is the best way to keep central bank independence alive.

Two. The central bank should help the government achieve broad economic goals to the degree that compliance with its mandate allows.

As a state body and by virtue of its independence, the central bank is entrusted with implementing certain economic policies: mainly monetary policy but also some aspects of exchange rate policy and financial system regulation and supervision. The goal is to achieve the central bank's primary mandate established by law. This delegation of faculties comes hand in hand with sound governance principles and a clear regime of accountability to the legislative branch and society as a whole.

As I have mentioned, ensuring low and stable inflation helps to achieve broader economic objectives, such as accelerated and sustained economic growth, lower unemployment, better income distribution and reduced poverty. This could be interpreted as indicating that the central bank should focus solely and rigidly on the achievement of its primary mandate. However, there could be circumstances in which the central bank could be somewhat flexible in helping the government pursue better economic performance, leading to greater societal benefits. If the central bank can influence in this way, without putting the achievement of its primary mandate at risk, it should do so. This approach would strengthen social and political support for its independence.

I am aware that this approach is not easy, and it certainly involves risks. If applied incorrectly, it could undermine the central bank's credibility. It is thus important to act very cautiously and prudently. The challenge is to appropriately identify the circumstances in which the central bank can interpret its mandate broadly and flexibly, but at the same time responsibly.

Allow me to illustrate this with three examples:

• If inflation is clearly below target, the central bank could loosen monetary policy. It would thus signal that it takes a symmetrical approach to positive and negative deviations of observed inflation from its target.
• Frequently, adverse variations in relative prices stemming from supply shocks can cause measured inflation to rise. We must remember that inflation is a generalised increase in prices. Thus, in principle the central bank might not need to respond by tightening monetary policy, especially if the abrupt variations in relative prices did not affect medium-term inflation expectations. In such a case, the deviation of inflation from its target is most likely transitory, rendering a policy response unnecessary. In fact, that policy response would affect the economy with a lag, only once the supply shock subsided. Central bank credibility and an effective communication policy would be essential to ensure a good outcome.
• In contrast, at times it could be appropriate to tighten monetary policy even if the path of actual and expected inflation were not incompatible with achieving the target. Financial market exuberance could herald instability down the line, which could have severe repercussions for economic activity and inflation. This situation could justify adoption of a tighter monetary policy intended to take some of the shine off the overflowing optimism in financial markets, even if the foreseeable path of inflation did not suggest it. In this case, in the absence of a more prudent monetary policy, an inflationary surprise could occur later on, accompanied by an abrupt deceleration of economic activity, which would certainly justify immediate action by the central bank.

The underlying message is clear: the central bank should not react mechanistically to deviations from its inflation target. The national and international macroeconomic context is always important for fine-tuning monetary policy, which tends to produce better overall results for society. Those good outcomes confirm the value of central bank independence. In my opinion, the Bank of Mexico has generally followed this approach.

Three. Economic policy coordination is fundamental to achieve low and stable inflation.

This is the logical consequence of an inescapable fact: monetary policy does not act in a vacuum. Even though, in principle, it is the policy that affects inflation the most, other policies also do. And factors that are not strictly monetary or financial in nature, such as globalisation and the rapid pace of technological change, play a role as well. In fact, low and stable inflation can be achieved much more quickly if the synergies between different economic policies are exploited and their limitations are acknowledged. In sum, countries should strive for a consistent macroeconomic framework that allows them to reach their growth potential with low and stable inflation. To achieve this they should seek to coordinate as much as possible, at the very least, monetary, fiscal, exchange rate, financial, trade and competition policies.

In short, the central bank's independence does not condemn it to isolation. This has been clear over the past 25 years. During this time, a low and stable inflation rate environment has become entrenched. Without a doubt, monetary policy has played its part, but the results also reflect effective coordination with other government agencies.

Four. Communication is a monetary policy tool which should be an integral part of a central bank's actions.

In order for society to believe in and support central bank independence, it must first understand it. For this to happen, the central bank has to explain clearly and tirelessly what it does, how policy tools work, how it expects its actions to produce the desired effect, and what environment it is working in. It should also explain its limitations and what is beyond its reach. This cannot be achieved without a good communication strategy.

When the Bank of Mexico's autonomy was designed, a quasi-fixed exchange rate regime was in effect, in which the nominal anchor of the economy - the exchange rate itself - was quite obvious. Against this backdrop, monetary policy implementation was relatively simple, and in principle there was little to communicate. But things changed drastically when Mexico moved to a flexible exchange rate regime and then an inflation targeting one. With this approach, communication is vital to ensure the effectiveness of monetary policy, as the effective anchoring of inflation expectations is of the essence. It goes without saying that communication is also key for accountability, which is one of the cornerstones of independence.

III. Conclusion

The Bank of Mexico's independence has functioned well, fundamentally because it has been exercised diligently. The benefits to society have been clear and very significant. I do not think I exaggerate when I say that the granting of autonomy to Mexico's central bank was one of the most successful structural reforms implemented in the country in recent decades. That is why I celebrate the Bank's 25 years of independence and hope that it will continue to protect the Mexican people for many years to come.