What if I'm Wrong about Monetary Policy?
#112, May 2025
It is difficult to be inspired to write a good post on schedule twice a week, and so some posts are better than others. This one has been delayed, and rewritten several times, and probably still needs more work. But I should move on to another topic, so let me share what I have. Criticism (and questions) welcome.
For the past several weeks, I have been especially critical regarding the conduct of monetary policy and the management of the central bank. It is not difficult to imagine that I am wrong and the man who has run the place for 27 of the last 31 years (and all the data) is right. It’s possible that circumstances really do dictate that key information about the bank’s plans and activities be withheld from the markets and public, to allow the BCRD to execute its strategy without anyone being sure what it is doing. After all, a small open economy is more fragile than a major industrial country, where swap lines—lending arrangements to permit large-scale borrowing at short notice among central banks when one faces a crisis—reduce the risk to financial stability.
I started to wonder whether I was perhaps wrong about the value of transparency and of more straightforward policies after watching, and then posting on Twitter about, a Wednesday interview with Bill Dudley, former President of the Federal Reserve Bank of New York (which is the part of the Federal Reserve that actually executes monetary policy).[1] In it, he explains why greater transparency, not only regarding information but regarding the decisions the Fed would take in various scenarios, it’s “reaction function”. The Fed runs a large, stable economy, and is tasked with maintaining inflation below 2% and, in the process, maximizing employment. Their only real tool is interest rates: higher rates=less inflation and fewer jobs, lower rates=more inflation and more jobs. And they control interest rates through the amount of reserves (deposits of banks at the Fed itself) it allows banks to hold.[2] One objective, one tool: it’s a fairly simple task to define how the Fed will react with interest rates in response to hypothetical inflation data.
The BCRD is charged by law with maintaining low inflation. Perhaps because exchange rate depreciation raises inflation (and inflation contributed to exchange rate depreciation), the de facto primary operation goal of the BCRD is maintaining a stable exchange rate against the U.S. dollar. Unwritten is a third objective: help maintain solid economic growth. So there are, in practice, no fewer than three objectives that the central bank is trying to attain. In order to meet the three objectives, the BCRD has established three sets of tools:
1. To stimulate economic growth, it has established the Rapid Liquidity Facility (FLR) to allow it to lend to banks to underwrite lending to the economy at preferential rates, ensuring that these loans are placed quickly. It has also developed a quite unorthodox policy regarding required reserves, under which banks are, when needed, freed of requirements to hold a share of their deposits from the public at the BCRD. The amount is variable, and not visible in the data. In addition, the BCRD policy over the past dozen or so years has been to reduce the share of deposits held at the central bank even in principle, in order to allow banks to use the money to increase lending to the economy.
2. To stabilize the exchange rate, the BCRD holds large amounts of foreign currency as international reserves. It can and often does also buy and sell dollars in the open market, thereby affecting the price of dollars (the exchange rate). It generally conducts what is called “sterilized” intervention, issuing bonds to absorb the pesos it puts into circulation in the process of buying dollars.[3]
3. To contain inflation, the BCRD can raise the interest rate on its loans to commercial banks. It can also limit the amount of loans it extends to banks or the securities it sells in the open market, reducing the supply of bank reserves and forcing banks to lend less to customers. The customers then spend less, putting less upward pressure on prices.
This looks like three tools for three objectives Is it really? And does the BCRD really gain from being unpredictable?
It is still true that the most powerful tool that any central bank has at its disposal is control over the supply of deposits hold with it, which determines how much a bank can lend. At the same time, I have written before (too often?) about the trilemma, the proposition that a central bank cannot simultaneously control capital flows, the interest rate, and the exchange rate (see Dominicanomics #60 from September 2024). And even controlling two out of the three, done badly, can create unsustainable outcomes. In most cases, only one of the three is realistically achievable, and, for this, most countries choose independent monetary policy, letting the exchange rate be set in the marketplace and capital to flow where it gets the best return.
The Balaguer administration, until the end of 1990, tried hard to control capital flows with coercive methods, including throwing people in jail; the outcome can best be described as “a mess”.[4] The Dominican Republic is too closely tied to the United States to effectively control capital flows. A central bank that wants to determine interest rates AND the exchange rate will face whatever flows those decisions imply: a low interest rate and a fixed exchange rate will create capital outflows, neither desirable nor sustainable.
Dominican interest rates are often presented as being independently set by the BCRD, but, as I showed in Dominicanomics #81 last December, this is true only in the shortest of horizons. There can be a differential between U.S. and Dominican rates, but any significant differential will start capital flowing, and the exchange rate moving, in response. A positive differential no doubt helped the BCRD to accumulate over $6 billion in international reserves, despite the pandemic, over the period 2020-2023—with $4 billion of that accumulated while U.S. Treasury bill rates were close to zero. A negative differential produces capital flight.
The observed choice of the BCRD is to focus on controlling the dollar/peso exchange rate. It is well established, however, that exchange rates can display momentum. That is, they have a tendency to follow a trend. For a currency like the Dominican peso with a long history of trending downward, there is a role for the central bank to serve as a circuit-breaker when the downward trend becomes exaggerated. We saw this in April, where a combination of regulatory changes and (most likely) other interventions completely reversed a 6.6% depreciation over the previous 12 months. (Was this too much? Time will tell.)
Can the BCRD use its different tools to influence these prices, growth, and the exchange rate under these circumstances? In the shortest of horizons, yes. I believe that one of the reasons for the limited transparency of the BCRD is that it allows the pretense of doing taking impactful measures in all three areas for longer than they are actually in effect. We saw the BCRD decide on May 31, 2025, to expand credit rapidly in response to growth of only 2% during the first half of the year. Yet the Bank started reducing liquidity (through its overnight bill issuance) after only a week:
It can be argued that the BCRD increased total credit directly to the economy, reducing liquidity that was not adding to credit while adding liquidity that was. Again, however, the question is, For how long? and at what cost?
The answers lie in the details, which are not generally published.[5] And this is where it becomes difficult to really decide, Am I wrong? How much real benefit has the BCRD been able to deliver for the Dominican economy by playing an unwinnable game in the dark? Surely some; but not for free.
To me, this looks like manipulation of the BCRD’s image rather than of monetary aggregates that produce real results for the Dominican economy. I may be wrong. However, I want to close with a chart from a recent newspaper chart by Andrés Dauhajre, showing how many years central bank governors are appointed for in different countries:
This chart highlights what may be the most anomalous thing about the BCRD: although the current governor has been in his position since 1994 (except for 2000-04), the Governor is only appointed for two years at a time, making the central bank a creature of the government, and the Governor’s reappointment dependent on his reputation for delivering on the government’s priorities. I believe people respond to their incentives, and the incentives here are self-evident.
[1] https://www.bloomberg.com/news/videos/2025-05-21/bill-dudley-on-the-fed-the-markets-and-the-unexpected-video
[2] When the short-term interest rates it typically manages went to zero, the Fed started working to bring down longer-term interest rates, too; this was unusual, but not a great change in the foundation of what it does.
[3] Interest on these bonds are an important part of why the BCRD’s losses are so large, equal to over US$1 billion in 2024.
[4] The best reference for this episode in English is Frank Moya Pons’ book, The Dominican Republic: A National History. There are various editions, but the chapter “Balaguer’s Return” (the last chapter in the first two editions) covers the period until Balaguer accepts economic reforms in all of them. (The Second Edition covers until Balaguer’s departure from the Presidency in 1996, and the Third Edition covers the first Fernandez and the Mejía administrations.)
[5] Even market interest rates are not published, the BCRD preferring to publish an average that includes subsidized rates, giving it a direct method to manipulate the published average.