Inflation Targeting in Latin America

Abstract

In this paper we analyze the implementation of inflation targeting in Brazil, Chile, Colombia and Peru. First we undertake OLS estimations of conventional Taylor rules and show that in all four countries the central bank increases its repo rate of interest in response to increases in the output gap and, except in the case of Peru, also to deviations of inflation expectations from established targets. Second, using a Markov-Switching methodology that allows the data to speak for itself , we find that in Chile, Colombia and Peru there is evidence that, in the presence of severe external financial shocks, central banks temporarily abandoned their conventional reaction function. Third, we expand the conventional Taylor Rule so as to include variables related to exchange rate misalignments and to developments in domestic credit markets. We argue that this inclusion is merited on account of the potential for these variables to anticipate episodes of financial fragility, not because they might contribute to explain output and/or inflation gaps. Interestingly, there is only limited evidence that the countries in our study have actually used some form of expanded or integrated inflation targeting framework.