We are living in troubled times. Some might stay that times are always hectic and the only thing that changes is the cause of the turbulence. For example the Covid-19 pandemic, with its direct consequences and the changes in habits that it has caused. In addition, the Russian invasion of Ukraine and the Israel-Hamas war, which have affected energy markets and various production chains, and increased geopolitical tensions in various parts of the globe.
We have seen rising inflation around the world. While the reaction of monetary authorities worldwide has been swift, several questions remain unanswered. How long will we have contractionary monetary policies? How well will countries withstand this scenario? Will this have consequences for financial stability? These are questions that are being raised everywhere on a daily basis.
In this regard, these times require a reaffirmation of the importance of the strong institutional framework of central banks, which are a central pillar for economic and financial stability, and therefore also a central pillar for stable growth. Strong institutions sustain trust.
In addition, I would like to highlight an increasingly important element in the actions of central banks besides their institutional strength. Such times require central banks to be more vigilant than ever, to be proactive and to be, if not ahead, then ever closer to what is happening. A passive, reactive role of central banks is not enough in troubled times.
And this goes for monetary policy as well as for financial stability. New challenges require better central banks.
Central banks have made great progress in the past 50 years, starting with institutional changes that have made them more independent and professional. Inflation targeting has become very efficient, managing expectations most of the time, allowing more room for monetary policy to provide cyclical assistance. Not immune to episodes of financial stress in these years, central banks implemented sophisticated prudential measures after the 2008 financial crisis that have prevented major damage to economies and allowed confidence to be restored quickly after each event. Clearly, if we compare the state of the art today with that of the early 1970s, the improvements have been substantial.
Rising inflation
Monetary policy has become the first challenge in this new environment. Inflation is back on the agenda after several decades in which it seemed tamed. The quick reactions of some central banks have been very important. Those who hesitated or preferred to wait in these times of trouble have found it harder to control inflation.
And here I want to hold up as an example the main central banks of Latin America, which rose to the occasion: they were the first to start contracting monetary policy, a clear sign of their commitment to keeping inflation low and using the credibility built up over many years.
Those who hesitated or preferred to wait in these times of trouble have found it harder to control inflation.
Brazil, Peru, Chile, Colombia, Mexico, and Uruguay are examples of prudent management, timely reaction and lack of speculation. The institutional restructuring that they have done in recent decades has paid off.
In Uruguay, when we took office in 2020, the government implemented an inflation-targeting regime that aims to be robust and end decades of high inflation. And we are determined to strengthen the institutional framework.
From the beginning, we clearly indicated our commitment to lower inflation; we began to use the interest rate as an instrument of monetary policy, and we made important changes in communication, doubling the frequency of the monetary policy committee meetings, permanently improving our reports and interaction with all economic agents. We moved forward with a de-dollarisation plan and were emphatic in maintaining a free-floating exchange rate regime. We have called all this “Towards a quality currency”.
Rigid inflation expectations were an obstacle caused by a history of inflation. Month by month we have seen improvements in expectations. Economic agents now understand the workings of our monetary policy. The permanent signs of commitment from the central bank have been very important
The results have started to come in. After more than 20 years at an average of 8%, today inflation is in the middle of the inflation target range and our projections maintain the monetary policy horizon.
I think that in our case it has been decisive to act in time and put monetary policy in a contractionary phase as soon as we understood that the main effects of the pandemic had passed and we were returning to normality.
Structural change
Monetary institutions have de facto improved, although it is important to introduce changes and consolidate them in law. There is still a long way to go. And we have to be proactive and anticipate problems in the functioning of the financial system.
The financial system is undergoing very important structural changes. It’s not just about banks anymore. Technology changes the way we do things on a daily basis. It generates opportunities and, of course, risks.
It is important to have regulation of the financial system that creates a level playing field to contribute to the collaborative development of the industry. Currently, the perception of an antagonism between the role of banks and fintech companies has changed; it is clear that we are moving towards collaboration, where each one will occupy their place and role in an increasingly collaborative environment.
The stability of the Uruguayan financial system represents a good starting point for innovation; sometimes stability is seen in contrast to development, but there is room to develop the financial system while maintaining that well-earned stability. Banco Central del Uruguay seeks to provide guides and signals about where regulation is going, so that the private sector can find the correct path to innovate and develop products.
Central banks are an important pillar for economic and financial stability. Image: Bloomberg
Also, Banco Central del Uruguay has created a roadmap committed to an interoperable and innovative fast payment system. Its main goal is to create conditions such that actors have incentives to innovate, incorporate best practices and develop new operations within a more modern payment system: solid, secure, with high standards of efficiency, accessibility and freedom of choice.
The promotion, together with the private sector, of a fast payment system will hopefully lead Uruguay to be in tune with other payment systems in the region and the world, and includes the intention to advance an open finance agenda that will involve, for example, improving communication channels and the distribution of information among the different participants in the system.
In this regard, regulators have to be ahead of the changes. Anticipate them as much as possible. Leave the way clear for changes to happen, so that innovators can act and allow better financial services to be provided to millions of economic agents around the planet. But central banks must be also very attentive to the inherent risks they may pose.
Making international payments in fractions of a second at very low cost, using a robot that allows us to decide our personal investments to improve our retirement, acquiring a portion of the production of an agricultural field that is registered on a blockchain, comparing insurance prices online — all these have improved the efficiency of our economies and therefore our well-being in recent years, and form part of that financial innovation we encourage.
However, cyber security threats have increased, jeopardising the privacy of our data. Recent bank runs caused by crises of trust led to a rapid contagion that was exacerbated by the ease with which funds can be moved.
Central banks have an obligation to be much closer to developments; they cannot continue to look from far away at new technologies and new industrial organisations. Carrying out research in technology is no longer an option — it is an obligation.
As such, central banks need to be proactive, learning and understanding new ways of operating. They need to make sure that they are not blocking innovation, but are enabling market players to have the right incentives to continue to create value, but at the same time anticipate risks and protect consumers.
The agenda is long. Central banks must rise to the challenge.
Diego Labat is president of Banco Central del Uruguay, Uruguay’s central bank.
