Gaining Degrees of Freedom: Monetary Policy Management in LATAM-5

By examining the reaction functions of the Central Banks of Brazil, Chile, Colombia,Mexico, and Peru (LATAM-5) over the period 2002-2019, this article explores the degree towhich the adoption of inflation targeting regimes allowed these economies to have greaterroom of manouvre in conducting their monetary policy. On the one hand, we find that policyrates respond more than proportionally to deviations in expected inflation over a one-yearhorizon. On the other hand, we find that monetary policy can respond countercyclically tofluctuations in GDP. However, our results also show that some of these Central Banks arenot entirely indifferent to the behavior of variables beyond those postulated in conventionalTaylor rules. We find evidence that in most cases, monetary authorities respond positivelyand systematically to movements in the policy rate of the FED. Is this regularity indicative ofrestricted monetary autonomy in LATAM-5? Or, on the contrary, is this behavior compatiblewith the prescriptions of an optimal monetary policy rule for a small and open economy? Todistinguish between these alternatives, we estimate a Vector Autoregressive (VAR) modelfor each of these economies. This allows us to analyze the response of monetary policy todifferent shocks and the transmission mechanisms to key macroeconomic variables, as wellas its interaction with the FED’s interest rate. Finally, our estimates shed light on howthese Central Banks, utilizing the hard-earned greater degrees of freedom, responded to theepisode of inflationary pressure following the pandemic.