The interest rate is also monetary issue – 09/08/2019

Daniel Falcon

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Economist

The result of the primary detonated the third exchange crisis of the administration of President Macri. In all three cases, the Government's reaction to avoid the dollar's rise was to raise the interest rate, and in all three cases the peso was devalued.

Why did these currency crises occur and why did the government fail in its attempt to break them? The root of the problem is in the misguided monetary policies that have been applied, that do not take into account the bimonthly nature of our economy.

Simplifying the operation of the money market, we can say that through its operations the Central Bank determines the money supply – the amount of money available in the economy – and the economic agents (individuals, companies) determine, based on their decisions and preferences, the amount of pesos (demand for money) that they are willing to retain in their different forms (cash, checking and savings accounts and fixed terms).

exist two reasons why which people demand money. The first is to deal with your daily transactions (transactional demand). The second is savings, money that they decide to retain to maximize their financial return and whose amount will depend on the current interest rate and the expected return on other alternative assets (bonds, stocks).

Simplifying, we can say that the transactional demand is mostly maintained in cash, checking accounts and savings accounts (M2), while the demand for savings purposes is kept in fixed terms (M2 + fixed terms = M3).

For there to be balance in the money market, the amount of currency in the economy must be equal to that which economic agents are willing to demand. When the Central Bank increases the supply of currency above what economic agents wish to retain, there is an imbalance in the money market, which will have different consequences depending on the economic context.

In the Argentine case, the bimonthly nature of its economy makes certain policies work differently than in the rest of the world. While in stable countries, its inhabitants tend to save in local currency, in Argentina, as a result of a long history of high inflation, liquefactions, asset confiscation and currency crises, economic agents only demand pesos for transactional purposes and allocate its surpluses in very high percentage to the purchase of dollars.

The demand for money is then purely transactional, including fixed deadlines, which channel temporary surpluses, that due to the volatility of the exchange market and the wide spreads that banks charge in the purchase and sale of currencies, it is not reasonable to invest them in dollars. Only a minor part of the fixed terms constitutes speculative demand for money; that demand that depends on the interest rate and the devaluation expectations.

That the bulk of the fixed terms are transactional demand can be inferred from the stability that over time shows the relationship between the demand for pesos (M3) and the GDP at current prices (indicator of the volume of transactions).

In spite of the enormous volatility that the price of the dollar shows in the period under analysis, it is observed that after the exit of the stocks in December 2015, the demand for money remained stable at around 20% of GDP. The fluctuations it has had have not exceeded, 1% of GDP. If the demand for money is stable and primarily aimed at satisfying transactional needs, any increase in supply above those needs will cause excess weights in the economy.

And this is precisely what has been happening and the cause for which could not contain the rise of the dollar. In this regard, it is very illustrative to analyze the current agreement with the IMF regarding monetary policy. In order to reduce inflation, the BCRA made a commitment to limit the growth of the monetary base to 0% per month, and not allow short-term rates to fall to less than 60% until inflationary expectations at 12 months have decreased bluntly for at least two consecutive months. This commitment is totally inconsistent.

First, it is not correct to take the monetary base as an indicator of the issue. The appropriate indicator is not the increase of the monetary base, but that of those of Total monetary liabilities of the Central Bank, which includes in addition to the base, the monetary absorption instruments (Leliqs) for which an interest rate is paid.

Second, keep the short-term monetary policy rate at 60%, cannot contribute to lower inflation, but as we will see next, quite the opposite. Analyzing the evolution of these two variables since the agreement was signed -September 2018 to July 2019- we see that while the monetary base remained constant, fulfilling the commitment assumed, the monetary liability grew in the same period at a rate of 43.4 % annual Why did the BCRA monetary liability grow? The answer is simple: by the accrual of the interest rate that pays for its liabilities (Leliqs). At a higher rate, higher growth of liabilities and ergo of the money supply.

Whenever the BCRA, in its attempt to increase the demand for money, the interest rate rises, it actually produces an increase in the supply of currency, causing greater imbalances than those who want to fight. The increase in demand that can be achieved by raising the rate is not structural but always speculative and as such, artificial and temporary. Sooner rather than later, the excess liquidity it produces ends up being channeled to the goods market producing inflation and to the foreign exchange market causing the devaluation of the peso.

That is why it is paradoxical that the IMF requires the BCRA to maintain high rates as a restrictive policy to stabilize prices and the exchange market. Is a monetary policy restrictive where the amount of money grows to more than 40% per year? Is it reasonable for this monetary expansion to lower inflation?

Inflation has been attempted to explain the dollarization of the economy and / or the inflationary inertia derived from the indexation of contracts, when in reality its main cause, although not the only one, has been the wrong monetary policy. Prices do not rise because the dollar rises, in reality the dollar rises as one more price (although the most important) because increase the amount of money at rates greater than 40% per year.

In an economy like Argentina, monetary policy It is expansive when the Central Bank raises the interest rate and contractive when it falls. If you want to lower inflation and control the exchange market, the appropriate measure is not to raise the interest rate but lower it. It is inconsistent to use the dollar as an anchor of the price system and simultaneously have an expansive monetary policy raising interest rates. This only increases the imbalance. It makes much more sense to do the opposite, anchor the growth of the amount of money through much lower rates and let the exchange rate float. The agreement signed with the IMF currently in force has its Achilles heel in the monetary policy committed and this is undoubtedly the main cause of its failure. Changing this policy is urgent, and a necessary condition for any stabilization plan that you want to implement.