Caracas Chronicles

Quico says: There’s one thing monetary authorities need more than anything else: credibility. When a Central Bank chief commits to a policy goal, he has to make sure he has the tools at his disposal to really make it happen. In a world of rational expectations, the general belief in a Central Bank’s ability to make its policy commitments stick is one of the most powerful determinants of a Central Bank’s actual ability to make its policy commitments stick.

So how credible did Central Bank of Venezuela chief Nelson Merentes’s target to keep the parallel rate below BsF.3.45 per dollar turn out to be? Ermmm…not very.

As you know, I’m not actually allowed to tell you the parallel rate today, but between you and me and 27 million other people, it rhymes with thive dolivars firty cents per bollar. That’s nearly three times the 60% gap Merentes says it’s the most he’ll allow.

In other words, the market had one look at his announcement, had a good chuckle, and went right on doing what it’d been doing.

It’s easy to laugh it all off, but this stunning monetary own goal could really undermine Merentes’s hold on the economy down the road. Once the market starts to discount the Central Bank’s announcements, the bank’s ability to actually keep a handle on the macroeconomy starts to evaporate: cuz Merentes can do what he want to the macroeconomic aggregates he control, but if people don’t believe he’s going to really do what it takes to achieve his goals, the market will just keep eating his announcements for breakfast.

Update: A reader retorts that, to be fair, Merentes only said the bolivar would rally to Bs.3.45 by early December, not right away. That’s true, as far as it goes, but irrelevant. If Merentes had any credibility, the bolivar would’ve rallied today.

To see why, ask yourself this: if you truly believed that the bolivar would rally to 3.45 by December, what would you do? Simple: you would rustle up as many dollars as possible and run, not walk, to the permuta market to buy bolivars at 5.40 while you still have the chance.

Then you’d sit pretty.

Come early December, you would take your bolivars and use them to buy dollars at BsF.3.45 a pop. Do that and you turn each October dollar into $1.56 in December – a better than 50% profit margin in just a couple of months.

I believe the technical term for that is “a killing”.

Now, you’re not the only one able to do that calculus. Anyone can. If the market had taken Merentes seriously, tons of people would’ve followed that reasoning and tons of money would’ve rushed to get in on the deal, lining up to buy up bolivars in the permuta market ASAP.

Via normal supply and demand – i.e., lots of dollars chasing relatively few bolivars – the rush itself would have driven up the value of the bolivar in the parallel market. In other words, we would’ve seen a mad scramble for bolivars in the permuta market, and that scramble would have continued until the gap between the expected value of holding bolivars and the expected value of holding dollars had been erased.

Which means that, if investors collectively had any confidence in the government bringing the permuta market to heel by December, we’d already have the evidence: the bolivar would’ve rallied to (near) 3.45:$ today.

That’s rational expectations.

The fact that the bolivar rally stalled at 5.40:$ tells you all you need to know about how seriously the markets took Merentes. They laughed off his announcement, man.