Late one night, a woman was walking and saw a man crouching under a lantern, frantically searching for something on the ground. He approaches and asks:
—Have you lost something?
– Yes, the keys to my house.
The woman offers him her help and starts searching with him. After not finding her for a long time, he asks:
“Are you sure you lost her here?”
—No, actually it was a few blocks before.
“And why are you looking for them here?” the woman asks curiously.
– Because there is more light here.
This old joke serves to illustrate a common mistake in economics, which is sticking to a particular theoretical approach to try to fix a problem when in reality the solution lies elsewhere. Which leads us to ask: How does Argentine President Javier Milei plan to reduce inflation? Will you unsuccessfully look under the lamppost for the solution or where the problem really lies?
The anti-inflation program pursued by the Milei government can be seen from the announcements and measures implemented by both the Minister of Economy, Luis Caputo, and the President of the Central Bank, Santiago Bausili.
At the monetary level, the aim was to sharply reduce the central bank's stock of interest-bearing liabilities by liquidating them in the face of inflation. The strategy was to significantly reduce the monetary policy interest rate, which rose from 11.1% to 8.6% per month, well below December's inflation rate of 25.5%. The reasoning – clearly monetarist – is that a higher interest rate was inflationary because it forced the monetary authority to spend more money to pay off the accrued interest on the interest-bearing liabilities in the hands of the banks.
Paradoxically, this change of course means the application of a very expansionary monetary policy, which – following the argument of the same approach – could have an opposite effect on inflation as intended (through the expansionary effect on investment, consumption and through prosperity via improving inflation). the price of financial assets).
At the exchange rate level, a drastic 120% increase in the exchange rate was undertaken with the aim of strengthening the central bank's international reserves, which are at historic lows. As is well known, the counterpart to this measure was its rapid transmission to prices, which, as already mentioned, led to inflation practically doubling in December compared to the previous month (25.5% and 12.8% respectively).
But the key is what happens from now on. Because the government's goal – and need – is to show that inflation is on a downward trend in the coming months. The two nominal anchors appear with which they will try to achieve this. In both cases, the logic is that they have a direct dampening effect on the rate of price increases and an indirect effect by improving inflation expectations.
Firstly, the announcement of a balanced financial result by the end of this year. It should be made clear that this includes paying interest on the debt, which requires a primary surplus of the order of 2% of GDP. To this end, the government forecast a drastic cut in spending of 3% of GDP, accompanied by an increase in tax collection of another 2% of GDP (necessary to correct the primary deficit of 3% of GDP that it is expected to face in 2023 will be closed). ).
As for taxes, the government announced that it will increase taxes on imports (by 0.8% of GDP), exports (by 0.5% of GDP) and high incomes (0.4% of GDP), in addition to money laundering (with the aim). attracting undeclared dollars that are outside the local financial system). On the expenditure side, the adjustment will focus mainly on the social component (retirement and social programs), estimated at 0.8% of GDP, subsidies for public service tariffs (0.7% of GDP), lower public investments ( 0.7% of GDP) and transfers to the provinces amounting to 0.5% of GDP (mainly to pay teachers' salaries and the health system).
The main aim of the idea of reaching a balance in public costs so quickly is to reduce to zero the monetary issue caused by the financing of the budget deficit, the main cause of inflation, according to Milei. In addition, the fiscal adjustment will lead to a significant decline in consumption, although this will almost certainly result in a recession (the monthly survey of consulting firms' forecasts conducted by the Central Bank assumes an average decline of 2.6%). 2024) will help limit price increases.
The other anchor is the exchange rate. Following the devaluation, the central bank announced that it would introduce a 2% monthly crawl path (also called a crawl peg) to curb price increases. What he did not make clear is how long he would maintain this exchange rate policy, which does not appear to be sustainable in the long term.
This becomes clear when forecasting the evolution of the bilateral exchange rate with the United States in the coming months compared to inflation estimated by the top 10 consulting firms that make up the aforementioned survey. As can be seen from the chart below, the exchange rate would already be at a similar level to before the devaluation by the beginning of March.
The market also does not believe that this exchange rate policy can last for long. Looking at the future price contracts, it is noticeable that they expect an increase of around 4% in February, although the biggest corrections would occur in March and April, both in the order of 11%.
How long this strategy can last largely depends on what happens in the official foreign exchange market, particularly the central bank's ability to accumulate dollars. So far it has worked: The monetary authority has amassed more than $4.3 billion in this first month of administration.
However, there is an important aspect that needs to be highlighted. According to a provision of the new management, access to dollars for payment of imports will be phased in, with the following deadlines once approved: (i) 25% starting from 30 calendar days; (ii) an additional 25% from 60 calendar days; (iii) a further additional 25% from 90 calendar days; (iv) the remaining 25% from 120 calendar days. This means that so far there has been no demand in the foreign exchange market from importers, who will only gradually gain access to it starting this week. This will certainly reduce the central bank's ability to accumulate reserves.
The other element that can have an impact is the exchange rate gap between the official exchange rate and the financial exchange rate. The reason for this is that the widening of the difference leads to an increase in devaluation expectations, which in turn leads to a slowdown in exports (both because in some cases they start to underprice to take advantage of this arbitrage, and because they choose to do so decide to wait before reaching an agreement). a higher exchange rate). For the same reason – but opposite reasons – it also accelerates import demand.
Here another source of conflict appears, because in recent weeks the financial exchange rate has risen steadily, accumulating by 30% and bringing the gap to over 50%, while at the end of December it was 5%. As it shows Here According to the consulting firm Romano Group, this led to a reduction in the number of exporters entering the foreign exchange market.
Although there are several factors that could have influenced the increase in the gap, there is no doubt that the decision to sharply reduce the interest rate in the context of an escalation of inflation (which led to the interest rate in real terms increasing from -2% to to -13%), causing part of the peso to migrate from fixed maturities and other domestic savings instruments towards dollar purchases, driving up its price.
In short, the measures and economic policy announcements show consistency, aligned with a monetarist perspective to combat inflation. However, just because they are consistent does not guarantee that they are effective. Reducing inflation – and doing so in a long-term sustainable way – is an extremely complex process because, as we have seen, it requires the simultaneous alignment and resolution of multiple fronts. But more importantly, if the diagnosis of the causes of the inflation process is not correct, it is most likely that inflation will not decline as the government expects, which will further strain the economic and social situation.
Should this happen and an even greater economic imbalance arise, Milei could use this as a pretext for dollarizing the economy – one of his main campaign proposals – which would undoubtedly be a major setback for the country, not only because it would mean an even greater adjustment ( the central bank does not have enough dollars), but because it would mean the loss of monetary sovereignty by the US economy. We'll know in a few months.
Juan Manuel Telechea He is director of the Institute of Labor and Economy (ITE) and author of the book Inflation! Why can't Argentina get rid of it?
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