San José, Costa Rica, since 1956

Costa Rican inflation: The 2007 breakthrough

From the print edition

Overall inflation in Costa Rica for 2012 has varied from 4.6 to 5.1 percent in April, May and June, as measured by the Consumer Price Index (CPI) annual forecast. If there are no extraordinary changes in the economy, inflation should continue in this range for the rest of the year. 

By comparison, U.S. inflation was at a 1.7 percent annual rate in June. Costa Rica has more than twice the U.S. inflation rate, but the Tico economy should grow more than twice as fast as the U.S. economy this year – a trade-off any entrepreneur will take.

On Tuesday, the Central Bank forecast growth for 2012 at 4.8 percent, higher than previous estimates of 3.8 percent.

Despite inflation numbers that are high in relation to the U.S. economy, Costa Rica is now operating in an inflation range that was an impossible dream for two generations. Before 2007, the Central Bank would have broken out the champagne if overall price increases could be kept to less than double digits in any given year.

In 2007, the Central Bank changed its method for fixing the exchange rate, from a predictable, mini-devaluation scheme to floating the colón and letting private buyers and sellers of dollars determine the exchange rate. To be sure, it’s a “dirty float,” with the Central Bank setting exchange rate floors and ceilings that trigger its intervention if the exchange rate gets too low or too high. But so far, the rate has been more or less stable since 2007, with Central Bank intervention only on the low end of its target range: {500 to the dollar. 

But at the time the Central Bank made the change to a floating exchange rate, it looked like a gamble – after 24 years, from 1983 to 2007, the economy had become accustomed to the relatively predictable mini-devaluations. During those years, total yearly devaluation averaged 11 percent. 

What happened to cause the Central Bank to want to fix a system that wasn’t broken? In hindsight, based on success with the floating colón, it would seem that the Central Bank was telling Costa Rica’s exporters that, after 24 years of coddling them with steady devaluation to make exports more competitive, it would now seek to stabilize the exchange rate and concentrate on what should be the No. 1 goal of every central bank: exchange stability with low inflation. 

In an open economy like Costa Rica’s, where exports and imports total more than 60 percent of gross domestic product, an 11 percent devaluation every year builds a big fraction of that into increased money supply (as exporters change dollars into colones to pay their local production costs), and the full devaluation rate increase into the price of imports. No wonder the country struggled to crack a 10 percent minimum inflation rate in those years when devaluation averaged 11percent.

What emboldened the Central Bank to float the colón in 2007? Most likely, the answer is changes in the Costa Rican economy. A generation ago, the big dollar earners for Costa Rica were coffee, sugar, bananas and beef – all agricultural commodities, in which Costa Rica competed on a price-only basis with lower-cost producers all over the world.

With those products and that competition, yearly devaluation was necessary to remain competitive. But today, Costa Rica exports mostly services and high-tech goods, and agriculture is only one-sixth of exports. For its modern export product mix, Costa Rica’s educated workforce provides the competitive edge, and the pricing crutch of yearly devaluation is no longer necessary.

Rudolf Lucke, a professor at the University of Costa Rica’s Institute for Investigation in Economic Sciences, a think tank, put together the chart pictured above left. Though it starts in 2009, not 2007, the chart shows the Central Bank’s success in bringing down inflation. The graph breaks annualized CPI changes down into component parts: regulated and non-regulated products, and exportable and non-exportable goods and services. 

In January 2009, the range of inflation components was all over the place, from a low of 11 percent for exportable goods to a high of 17 percent for non-exportable goods. In three years and four months, all the inflation-rate components have converged to between 4-6 percent – a stunning achievement, and the greatest help the government and the Central Bank can give to the poor, who are hardest hit by the inflation tax.

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