Increased autonomy of central banks helped fight hyperinflation, studies show – 02/15/2023 – Market

In the 1980s, Brazil and several countries faced strong waves of inflation. In the early 1990s, prices increased by more than 50% in a single month.

However, these peaks became rarer and inflation more controlled from the mid-1990s onwards. According to studies, one of the main reasons for this stabilization was the gain in autonomy of central banks in combating price increases.

In these studies, autonomy is understood in a broad sense (not necessarily the framework approved in Brazil in 2021, which defined, among other things, mandates for the presidency of the Central Bank). The gradations range from the freedom to define interest rates to the power to point out the objectives that the autarchy itself will seek to achieve.

Based on these autonomy indices, studies compare the inflation rates of different countries over the years. A survey by the Fed (Federal Reserve, the US central bank) of St. Louis points out that, in the 1980s, there were at least 13 developed economies whose central banks had low autonomy, and none with strong independence. In 2003, the situation had been reversed: there were 13 countries with autarchies with great autonomy.

At the same time, average world inflation, as measured by the IMF, no longer peaked above 20% after 1994, and remained at around 5% per year for many years.

“Greater independence led to a steady decline in inflation both in the pre- and post-1970s (when the US abandoned the gold standard) and before and after the wave of central bank reforms in the 1990s,” points out the study “Central Bank Independence and Inflation in Latin America—Through the Lens of History” [Independência do Banco Central e Inflação na América Latina pelas Lentes da História]by IMF researchers Luis Ignacio Jácome and Samuel Pienknagura, released in September 2022.

However, there is no clear causal relationship between central bank autonomy and inflation control, economists ponder, noting that other factors, such as increased productivity and trade integration, also affect economies and price indices.

“The evidence is favorable, but I have the impression that it is not conclusive. It is very difficult to identify the specific effect of central bank independence on other dynamics that are occurring simultaneously in that same society”, says Samuel Pessôa, a researcher at the Brazilian Institute of Economics at FGV and columnist for Sheet.

“The evidence is robust, but a classic test of causality is more complicated”, evaluates Arminio Fraga, former president of the Central Bank of Brazil (1999-2002).

Fraga considers that in several recent cases of uncontrolled inflation, local central banks lacked autonomy. “In Argentina, Venezuela and Turkey there were autocratic systems, with no independence from anything, even if there was something on paper,” he says.

“There is always a question of how much autonomy [do banco central] led to an improvement, by generating more credibility to monetary policy, and how much came from other characteristics of the country, such as having greater fiscal responsibility or not having an indexation history like ours”, questions Orlando Assunção, professor of economics at Faap.

How to measure the autonomy of a central bank

Another complex point is how to measure the autonomy of central banks. To quantify this, researchers usually consider aspects such as legal authorization for institutions to fight inflation and shields that protect their directors from dismissals and political pressure.

“It’s hard to hit the hammer on the level of independence. There are several conditions that may be on paper, but not in practice, and vice versa”, considers Alexandre Andrada, professor of economics at UnB (University of Brasília).

He cites the case of Brazil as an example: the BC only obtained official autonomy in 2021, but several previous governments, such as those of Fernando Henrique Cardoso (1994-2002) and Lula (2003-2010) gave freedom for the entity to run the monetary policy, even if presidents made public criticisms of interest rates.

Central banks emerged in the 1920s in Latin America

The debate over the autonomy of monetary authorities lasts for more than a century. In Latin America, the first central banks were created in the 1920s.

At the time, they had a certain independence and their main mission was to issue currency and maintain the gold standard: to ensure that the money in circulation was backed by gold reserves or other strong foreign currencies. One of the mottos of the time was “we have gold because we cannot trust governments”.

However, with the Great Depression of the 1930s, the gold standard was abandoned and central banks lost their autonomy. Governments in crisis wanted to print more money to pay their bills or use the official banking structure to obtain loans, in a movement that increases inflation later on, creating a vicious cycle.

Thus, from the 1940s onwards, many central banks in the region became a kind of development bank, to finance government projects. However, doing this at the same time as they needed to control the stability of national currencies generated imbalances and crises in countries like Argentina and Chile in the following decades, points out a study by the IMF. Both suffered coups d’état in the 1970s.

“In the 1960s and 1970s, with rising inflation, many central banks pursued a proactive policy, changing course all the time. This began to generate discomfort among economists”, points out Andrada.

At this time, works by researchers such as Milton Friedman (1912-2006) analyzed whether central banks should act more precisely. From then on, literature began to emerge that recommended giving them more power.

“There is a temptation on the part of politicians to generate inflation and heat up the economy in the short term. This generates some economic growth, but it is unsustainable, as it explodes at the front”, says Andrada.

In the 1980s, US and UK central banks raised interest rates, which led to capital flight from Latin America, which worsened the situation on the continent. In response to the crisis, local governments began to give greater independence to central banks from the 1990s onwards, repeating something that was done in rich countries in the previous decade.

Brazilian BC was created in 1965

In Brazil, the Central Bank was only created in 1965. Before, since the time of the Empire, the issuance of currency and other monetary policy actions were the responsibility of Banco do Brasil.

The BC had its powers expanded with the 1988 Constitution, which prohibited it from making loans to finance public spending. As of 1999, Brazil adopted an inflation targeting regime, and the mission of ensuring that these targets were achieved was with the Central Bank.

The Brazilian BC had autonomy guaranteed by law in 2021. The entity is free to use mechanisms such as the interest rate to try to bring inflation to the target. However, the decision on which objective will be achieved comes from the CMN (National Monetary Council), formed by the ministers of Finance and Planning, in addition to the president of the Central Bank.

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Chronology – Central Banks in Latin America

1920s
Latin American countries begin to create Central Banks, to maintain the stability of local currencies, whose value was usually guaranteed by gold reserves

1930s
Great Depression in the USA generates a strong crisis in the continent and several countries abandon the gold standard. Governments withdraw autonomy from BCs so that they can print money without backing, which worsens the long-term crisis

1960s
With high inflation in the world, economists start to defend more power to BCs to tackle the problem

1970s and 1980s
USA abandons the gold standard as guarantor of the dollar, oil crisis increases prices and developed countries, in response, begin to test models of BCs with more autonomy

1990s
Latin American countries are beginning to give more autonomy to BCs. In Brazil, the Real Plan manages to tame inflation from 1994 onwards. In 1999, the country adopts an inflation targeting system, which is still in force

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