The direct factor in reducing inflation is the reaction of monetary aggregates, that is, the monetary base or the number of bills and coins in circulation, to movements in the interest rate.
Central banks abandoned the monetary targeting scheme for the target interest rate scheme some time ago, in an attempt to reduce volatility in the money market, since under the monetary aggregates approach there is no full control over the interest rate. interest.
However, the current inflation targeting scheme requires certain conditions for its success, among which fiscal non-dominance stands out, and another that I introduce here, which is the accurate and sufficient response capacity of the monetary aggregate to changes in the interest rate. of interest.
The money aggregates or liquidity in the system can be looked at on a typical supply and demand graph, as the quantity of money demanded in the system at a given interest rate level. This liquidity demand curve (price-quantity) does not always respond in the same way to rate movements. For example, if the economy is over demanding liquidity, interest rate increases will have less effect on the quantity of money demanded. We know this as price inelasticity of demand.
This is what is happening with monetary policy in Mexico since its turn in July 2021 to date. It should also be emphasized that, in addition, this turnaround has happened slowly if we compare it with the sudden and accelerated increase in liquidity that happened a year earlier in 2020.
When the demand for money is insensitive to changes in its price (interest rate), it will take more time and more rate increases for inflation to slow down to its target. For this reason, despite the fact that the target interest rate is already at 10%, the growth of liquidity in the system reported a nominal rate of 12% in October 2022. With these liquidity growths, a reduction cannot be expected. of inflation.
To label monetary policy as restrictive, the interest rate is not the best thermometer. As I mentioned before, the rate is subject to the preferences or money requirements of the public at any given time. In fact, the monetary restriction or discipline is to limit the excess amount of money, to such an extent that the monthly growth of the monetary aggregate is 0% or negative in real terms. The United States and Brazil, for example, have already implemented it. For this reason, betting on a target rate level to reduce inflation is of little use if the accelerated growth of the monetary aggregate is not reduced.