In December 2015, a new government took office in Argentina. The Kirchner administration lost the presidential election, marking the end of a 12-year populist experience. The new government inherited an economy that had been in stagflation since 2011, with inflation rates in the 25-35 percent range, high poverty rates, recent default on the sovereign debt, incredible tax pressure, and one the least free economies in the world. To put it mildly: the country was a mess.
To reduce inflation and keep the Argentine peso stable going forward, the Macri administration adopted an inflation-targeting regime. But, just 26 months after its implementation in September 2016, the inflation-targeting regime had failed. It had consistently overshot its target and then revised its target upward (indeed, to a rate above that of the previous administration) before it ultimately abandoned inflation targeting altogether.
Why did inflation targeting fail in Argentina? There are three reasons:
- Naive expectations
- Lack of credibility
- Weak policy design
The Argentine central bank was too optimistic about the effects of inflation targeting. While countries adopting an explicit inflation target have seen lower inflation rates, so too have other countries. The effect is more pronounced under inflation-targeting regimes, to be sure. But many of those countries adopted a target after rates were already on the decline. Taken together, the evidence suggests that, at best, adopting an explicit inflation target results in a modest reduction in inflation rates and, perhaps more likely, that an explicit inflation target is better suited to lock in low rates than to reduce high rates.
A history of high inflation naturally makes Argentinians skeptical of promises to keep inflation low. But the central bank reaffirmed that skepticism by revising its inflation target. On December 28, 2017, with the annual inflation rate above 20 percent, the central bank increased its target from 12 to 15 percent. Perhaps more importantly, the way the central bank made the announcement caused many to doubt it was truly independent from the executive branch. Fearing that policy might be further adjusted to suit the president, Argentinians adjusted their inflation expectations upward.
Lastly, one must recognize that Argentina’s inflation-targeting regime was poorly designed from the start. Since the central bank lacked liquid assets to conduct open market operations, it decided to issue its own bonds to sterilize increases in the money supply. But issuing central bank bonds is, in effect, a promise to expand the money supply in the future. It is hard to keep inflation expectations low if today’s sterilization portends tomorrow’s expansion. And, since it becomes more costly to keep inflation low as inflation expectations increase, a vicious cycle ensues. The central bank issues bonds to sterilize new money, pushing inflation expectations up. The public thinks it less likely that the central bank will stay the course, given the higher cost, resulting in even higher inflation expectations. Rinse and repeat. In the end, the sizable carry-trade operations that resulted from the issuance of high-rate central bank bonds were liquidated, triggering a currency crisis in May 2018. And the central bank responded to the crisis by abandoning its inflation target.
Reducing inflation is a difficult and unpleasant endeavor. It requires a clear head, strong will, and well-designed approach. Argentina missed the mark on all three margins. It was overly optimistic about the benefits of inflation targeting, failed to makes it commitment credible, and adopted an approach that ultimately undermined its efforts. One can only hope that policy makers learn from these mistakes.