As part of the revised agreement between Argentina's government and the International Monetary Fund (IMF), the Central Bank of the Argentine Republic (BCRA) scrapped its inflation targeting regime and replaced it with a target of zero growth in nominal terms in the monthly average of the monetary base from October 1 until June 2019.
On Friday, when BCRA's monetary policy committee (Copom) began implementing its new monetary policy, the rate on Leliq 7-day liquidity notes rose to 65 percent from 60 percent. On Aug. 30 the Leliq rate was raised 150 bps to 60 percent under its defunct inflation targeting regime.
To reinforce the contractive nature of its new policy and prepare for the elimination of the stock of 35-day Lebac notes, BCRA also raised the reserve requirement for major banks by a further 300 basis points to what local media reported as 44 percent. The requirement has been raised several times in recent months.
The central bank's new policy framework includes limited intervention in the foreign exchange, mainly to prevent excessive fluctuations in the peso. In Argentina the exchange rate of the peso plays a major role in determining inflation expectations.
"This measure we are taking implies a significant monetary contraction that is necessary to recover nominal stability and reduce inflation expectations," new BCRA Governor Guido Sandleris said in his inaugural press conference on Sept. 26.
Sandleris, who has worked for the Minneapolis Federal Reserve, Chile's central bank and the International Monetary Fund (IMF), replaced Luis Caputo as the third central bank president since Mauricio Macri won the presidential election in December 2015.
Under Federico Sturzenegger, the first governor under Macri, BCRA in September 2016 formally adopted an inflation targeting regime, a system used by most central banks worldwide.
But Sandleris acknowledged Macri's government had made mistakes by underestimating the difficulty of correcting past imbalances and the inflation targeting regime had not led to lower inflation, the central bank's primary objective.
Argentina's inflation rate has risen steadily this year but remains below 40.5 percent that was set in April 2016. In the following months and throughout 2017, inflation decelerated.
But this trend came to an abrupt halt but in May this year as the peso plunged, setting the stage for the US$50 billion, 3-year support agreement with the IMF in June.
Argentina's inflation rate accelerated to 34.4 percent in August and BCRA expects it to exceed 40 percent in coming months as prices continue to adjust to the fall in the peso in August.
BCRA picked the monetary base - the sum of all currency in circulation and banks' deposits with the central bank - as its new nominal anchor because this monetary aggregate is its most direct control and therefore strengthens its commitment to comply with the goal.
Targeting the monetary base implies a significant monetary contraction as it recently has been growing a bit over 2.0 percent a month and now will no longer grow. With inflation continuing to rise, it will lead to a strong contraction in the monetary base in real terms.
Data on the monetary base is published daily so Sandleris said anyone can verify the central bank is living up to its commitment that the monthly average of the monetary base doesn't grow.
During December and June, when demand for money rises, BCRA will adjust its target to avoid excessive monetary contraction.
Although BCRA is formally using a floating exchange rate regime without intervention, it will use zones of intervention and non-intervention to provide transparency and predictability.
The non-intervention zone is initially set between 34 pesos and 44 pesos per U.S. dollar, with this zone adjusted 3 percent per month until end-2018. BCRA considers this range as adequate for exchange rate parity and will adjust the zone next year.
Within this zone, BCRA will not operate in currency market but instead focus on maintaining zero growth in the monetary base through auctions of Liquidity Letters (Leliq), which means the rate will fluctuate daily."The monetary policy rate is defined as the average rate resulting from these operations, calculated on a daily basis," BCRA said on Friday, adding the policy rate thus will be determined by supply and demand for liquidity, and comply with the commitment to zero growth in the base.
If the peso depreciates beyond the upper limit of the non-intervention zone, BCRA will sell up to US$150 million a day to prevent what it describes as "unjustified fluctuations."
The pesos purchased in such intervention will be withdrawn from circulation, reinforcing the contraction of the monetary base.
In the event the peso rises rapidly to less than 34 to the dollar - a sign of confidence and demand for pesos - the central bank may buy international reserves and decide how much to sterilize these purchases according to the economy's conditions.
"Only in the face of this signal of increased demand for money, can BCRA increase the monetary base above the 0% growth target, which will be supported by the increase in reserves," BCRA said.
In light of Argentina's commitment to stronger reform measures, the IMF on Sept. 26 increased its support of Argentina by US$7 billion to $57.1 billion through 2021 and front loaded the support so $19 billion were made available through the end of 2019 to calm fears the country couldn't meet its obligations.
Importantly, these funds are no longer considered precautionary but will actually be used to support the government budget.
In addition to strengthening its commitment to reduce inflation, Macri's government has undertaken to have a balanced budget by 2019, one year earlier than previously planned, and then a one percent primary budget surplus in 2020 to start reducing public debt.
The currency market greeted the revised IMF agreement and Sandleris' arrival by selling off the peso, which ended last week at a new record low of 41.30 to the U.S. dollar.
Today the peso firmed slightly to trade at 40.8 to the dollar and is down 54 percent this year.
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