APRIL 1, 1994 DECEMBER 31, 1994
BANCO De MEXICO
MAY, 1994
GOVERNOR
MIGUEL MANCERA AGUAYO
DEPUTY GOVERNORS
ARIEL BUIRA SEIRA
FRANCISCO CIL DIAZ
JESUS MARCOS YACAMAN
GUILLERMO PRIETO FORTUN
PREFACE
In accordance with Article 51, Section I and the fourteenth Transitory Article of the Law of Banco de Mexico, this institution's Board of Governors submits to the Federal Executive and the Congress of the Union this report on monetary policy for the period April 1, 1994 - December 31, 1994.
Introduction
In accordance with Article 28, paragraph six, of the Mexican Constitution and the regulatory law of Banco de Mexico, as of last April 1st the Central Bank's primary objective is to seek the stability of the domestic currency's purchasing power.
In order to fulfill this mandate, the Bank has the power to manage its own credit autonomously, which may be defined as the capacity to determine monetary policy. Despite that power, it is impossible for the Central Bank to control price evolution precisely. A wide range of factors have an impact on the inflationary process, over which Banco de Mexico is unable to exercise direct control. Thus, it is important to analyze the context in which monetary policy is conducted. The first part of the report is devoted to this analysis, with a review of the economic situation during the first months of 1994 for which data is available. Other documents, such as Banco de Mexico's Annual Reports, examine events that occurred before January 1, 1994.
Given that the Central Bank does not have the power to directly determine the prices of goods and services in the marketplace, it must, as any other central bank, act on certain variables that, in addition to influencing the overall price level, may be directly affected by monetary policy. These considerations are addressed in the second part of this report.
In complying with the mandate to procure the domestic currency's purchasing power stability, it is befitting for the Bank to establish quantitative objectives. Thus, the third part of this document sets forth the targets for increases in the general price level, as well as the periods for achieving them.
I. ECONOMIC SITUATION DURING THE FIRST MONTHS OF 1994
1.1 Background and Overview
In 1993, stabilization and structural reforms continued to move forward. With the economic strategy that has been followed for more than a decade, the profound macroeconomic imbalances prevailing in the early eighties have been significantly reduced and a sound basis has been established for a new stage of economic growth.
During the last year, for the first time in more than two decades, the inflation rate fell below 10 percent, reaching a level of 8 percent in December. This was the result of the efforts made in the last few years to strengthen public finances of monetary policy management, and of the exchange rate regime, in the context of a greater opening of the Mexican economy.
The process of structural change and greater public and private sector investment have promoted substantial improvements in labor productivity and in economic efficiency in general. This has brought about an important increase in average remunerations in the manufacturing sector, of 39.3 percent in real terms from January 1989 to February 1994.
Furthermore, greater efficiency has strengthened the competitiveness of the domestic productive system, promoting an outstanding performance in the non-oil sector. This sector has undergone important structural reforms stemming from the trade liberalization process that began in 1985 among them a greater diversification of merchandise sold abroad and a more appropriate pattern of exports given the country's comparative advantages. Thus, as of 1985 the Mexican economy ranks as one of the economies with the fastest growth rate of exports.
Although significant progress was made in different fields during 1993, economic growth was modest (0.4 percent). The slowdown in economic activity was mainly due to the weakening of private sector spending, especially investment. This investment performance is expected to be temporary, since it has resulted from transitory causes. Among such factors are uncertainty about the ratification of the North American Free Trade Agreement (NAFTA), which prevailed until last November, a greater than expected fall in inflation, and the revision of credit policies by banks and the resulting impact on the rate of credit expansion. The temporary nature of these factors, together with the improved perspectives for the United States economy and those of other industrialized countries, will stimulate the Mexican economy this year.
Nevertheless, economic activity and the domestic financial markets have been affected during the first months of 1994 by several adverse events. Political developments combined with greater volatility in international financial markets have been reflected in a rising exchange rate within its floatation band and a considerable increase in interest rates, both in nominal and in real terms. The environment of uncertainty appears to be causing a lag in investment and durable consumer goods purchases. To the degree that these circumstances are not permanent, neither will be their impact on production and employment.
The financial authorities did not prevent the rise in interest rates determined by market forces, as such action would have involved an exaggerated expansion of central bank credit, which would have put the stabilization program at risk. What the authorities did, however, was to promptly take complementary measures to preserve the public's trust in the program.
Thus, both in January and in March, the Pact for Stability, Competitiveness and Employment (PECE) was ratified, thereby reaffirming previous commitments by the signing parties. The Federal Government reiterated its mention to maintain a balanced fiscal budget. In addition, both with the margins brought about by the correction of public finances and the rescheduling of outlays, the government intends to give priority to promoting economic growth and employment, and increasing and making more efficient social spending. The current exchange rate regime was confirmed, as well as the commitment to determine contractual wage increases according to expected inflation plus improvements in labor productivity.
In general, the first months of 1994 were characterized by a moderate increase in economic activity and a continuing downward trend in the rate of inflation. The external sector enjoyed a favorable export growth rate, notwithstanding the decrease in international oil prices in the first quarter of 1994, with respect to the same quarter of the previous year. The rate of growth of imports, which dropped substantially last year, picked up early this year. This may be associated with a modest recuperation economic activity and, possibly, with the concentration the first months of 1994 of some purchases that we postponed in late 1993 in anticipation of reduced tariffs under NAFTA.
1.2 Production and Employment
During the first quarter of 1994, economic activity grew moderately. According to the National Institute of Statistics, Geography and Informatics' (INEGI) figures, during the first three months of the year GDP increased by 0.5 percent in real terms, relative to the same period in the previous year. This figure compares favorably with the decreases of 0.8 and 0.1 percent for the third and fourth quarters of 1993. An upsurge in the growth rate of production was recorded despite the fact that working days in the first quarter of 1994 were 2.7 percent fewer than during the same quarter in 1993, due to the Easter Week holidays (which fell in April in 1993). This had an unfavorable impact on some sectors' output, in particular the manufacturing industry's (see Table 1).
In the first quarter, primary sector production contracted 3.8 percent in annual terms, as a result of the combination of decreases in agricultural and forestry output and increases in livestock and fisheries production.
Industrial activity rose by only 0.1 percent in the first quarter of 1994, compared to the same period of the previous year, with favorable variations in mining (4.2 percent), construction (4 percent), and electricity (4.5 percent). On the other hand, manufacturing production decreased by 1.7 percent, although it should be noted that this sector's output has been recuperating from October 1993 onwards, as can be seen in the corresponding "trend series" in Graph 1.
It should be stressed that three out of the nine divisions in the manufacturing sector registered a rise in production, outstanding among which were the base metals industry (9 percent), and the machinery and equipment industry (3.3 percent). In contrast, production in the remaining six divisions declined in the January-March 1994 period.
Service sector GDP increased 1.4 percent in the first quarter of 1994 in relation to the same quarter of the previous year. Divisions recording the highest growth rates were transportation and communications (4.2 percent), and financial services. insurance and real-estate (4 percent) . Production of communal, social and personal services (educational, medical, amusement, rental and repair services) rose moderately (0.9 percent), whereas the retail, restaurants, and hotels divisions decreased (0.3 percent) .
Employment in the formal private sector can be measured by the number of employees affiliated with the Mexican Social Security Institute (IMSS). This figure registered a 0.3 percent reduction in the first quarter of 1994 with respect to the same period a year earlier a rate similar to that observed throughout 1993. This fall is attributable to a decrease in the number of permanent workers (0.6 percent), since seasonal employment increased by 1.2 percent (see Table 2 and Graph 2). It should be noted that there was a contraction in the number of insured workers in the extractive and manufacturing industries (11.0 and 3.1 percent, respectively). On the other hand, the work force employed in the in-bond export ("maquiladora") industry increased by 4.7 percent in the first two months of 1994, compared to the same period in 1993, after having increased 7.1 percent in 1993. Finally, the rate of open unemployment in urban areas was 3.8 and 3.7 percent in January and February, respectively. These figures are higher than those recorded in the same months of 1993 (3.2 and 3.5 percent), and in the fourth quarter of 1993 (3.3 percent).
1.3 The External Sector
In the first quarter of the year, total merchandise exports increased by 17 percent with respect to the same period of 1993. This was possible, despite the fall in crude oil exports value of 19.5 percent, because of the 23.9 percent rise in non-oil exports.
In regard to sales of non-oil merchandise abroad, two of the three groups recorded significant increases: manufacturing and extractive exports. Manufacturing exports rose 25.7 percent in those three months, a rate substantially above the 17.7 percent rate observed in 1993. By March, manufacturing exports had registered annual growth rates above 20 percent for six straight months, with an average growth rate of 25.2 percent. Moreover, it should be noted that in the first quarter of 1994, as in 1993, exports of manufactures in the non-in-bond (non-"maquiladora") sector were greater than those of the in-bond sector. Thus, the former increased by 26.9 percent (18.5 percent in 1993), while the latter increased by 24.5 percent (17 percent in 1993).
After having declined for several years, extractive (non-oil) exports increased 37.4 percent in the first quarter of 1994 with respect to the same period of 1993. This is explained mainly by higher international prices of several products in this sector. Agriculture and livestock exports, in turn, increased 7.2 percent in this quarter, compared to the figure for the same period in 1993.
During the first quarter of this year, imports grew at a higher rate than in the same period of 1993. The value of these acquisitions increased 17.5 percent, compared to figures recorded during the first three months of 1993. This growth rate recovery was the result of at least three factors: first, a large percentage of the rise in imports depends on the increase in future exports, since a considerable portion imports is used as inputs in the production of export-bound goods. Therefore, when the rate of exports accelerates, a corresponding increase in imports is to be expected. Second, the upsurge in imports is associated with a modest recovery in investment and consumer expenditures that began late last year. Third, the rise in purchases is probably due to the fact that these were postponed at the end of last year, in expectation that NAFTA and its tariff reductions would be put into force. The slowdown in the growth of imports over the course of the year appears to confirm this.
In the January-March 1994 period, the trade balance showed a deficit of 4,297.8 million dollars, exceeding by 682.4 million the deficit registered in the same quarter of the previous year. In this quarter, the current account of the balance of payments recorded a deficit of 6,700.9 million dollars, 17.4 percent above that observed in the same period of 1993.
During the first quarter of 1994, direct foreign investment inflows amounted to 1,787.7 million dollars, equivalent to 36.5 percent of the total recorded in 1993. This quarterly figure is the highest registered during the last five years. The corresponding inflows were mainly channeled to the manufacturing, service, retail, and construction sectors.
Furthermore, in the first three months of the year, private non-banking firms received net foreign financing of roughly 2,715 million dollars, which represents a 37.9 percent increase compared to the same period in 1993. During the first quarter, the public sector attracted foreign resources totaling 1,283.8 million dollars, which were obtained mainly through the issuance of bonds. In addition, Mexican commercial banks attracted net financing from abroad of 1,966.9 million dollars in the first quarter, which was markedly above the amount recorded in the same period of 1993.
Net financial inflows through the purchase of government securities 'by foreigners amounted to 1,486.6 million dollars in the first quarter of this year. As for the stock market, foreigners purchased shares in Mexican firms listed on the Stock Exchange of 3,465.6 million dollars in the first quarter, nearly three times the figure reported for the same period in 1993.
I.4 Public Finances
The Secretary of Finance has recently given a detailed account on this subject to the Honorable Congress of the Union in the document entitled 'Reports on the Economic Situation, the Public Finances, and the Public Debt'. This section reviews some of the issues mentioned in that document, on the context in which monetary policy has been implemented.
During the first quarter of 1994, the targets for the public finances were satisfactorily fulfilled, with a surplus of 522.2 million new pesos. In this period, expenditures were influenced by schedule adjustments, since outlays that are generally made at year's end were made in advance. The rescheduling is aimed at strengthening the economic recovery in the first part of the year. It is worth noting, however, that the new public expenditure schedule is consistent with achieving a balanced budget for the year. As for public revenues, these continue to improve, especially in light of the fact that economic activity has been growing below its potential.
I.5 Inflation and Wages In the first months of 1994, a monetary policy consistent with the anti-inflation effort continued to be implemented, and public finances were maintained under strict control. Together with the opening to foreign trade, the coordination of such policies with actions agreed under the current stage of the Pact (foreign exchange, wage, and basic prices policies), as well as lower inflationary expectations, has resulted in the continued downward trend of inflation (see Graph 3). The National Consumer Price Index (NCPI) increased by 7 percent from April 1993 to April 1994, which compares favorably to the 10.1 percent rate recorded for April 1992- April 1993, as well as to the 8 percent rate for December 1993. In each of the first four months of this year, the monthly increase in the NCPI was below that observed in the same months of 1993 (see Graph 4). In fact, the annual inflation rate for April 1994 is the lowest since January 1973. It should also be noted that for eleven consecutive months the annual percentage rise in prices has been an increasingly smaller single digit. The National Producer Price Index, excluding export crude oil, registered a 5.8 percent annual increase in April of this year. With this result, there have been sixteen consecutive months in which the annual increase has been only one digit. Furthermore, the index's accumulated increase in the first four months was 1.9 percent, the lowest rate recorded during the first fourth months of any year since 1980, when the producer price index was first calculated. It should be noted that goods and services are fully supplied, which demonstrates that there is no repressed inflation. Furthermore, without repressed inflation, the price structure is now consistent with the conditions of supply and demand for goods and services. In order to analyze inflation in the first four months of 1994 in more detail, the 302 items in the basket of the NCPI should be classified into four groups: a) products in the basic basket; b) non-basic merchandise, excluding fruits and vegetables; c) non-basic services; and d) fruits and vegetables. The price behavior of such groups of products in the first four months of both 1993 and 1994 is shown in Table 4. Prices of group (b), which is entirely composed of tradable goods, recorded an accumulated increase of only 1.6 percent in the first four months of 1994. It should be noted that this group of goods represents nearly one third of household expenditures. On the other hand, in the first four months of 1994, the accumulated price increase of basic merchandise was the highest of those shown in Table 4. Traditionally, prices of such goods increase at a faster rate early in the year, but not in overall annual terms. Thus, it should be expected that in the remaining months of 1994 their increase will be lower than that of other prices in the general index. As for the prices of fruits and vegetables, their accumulated variation in the first four months of the year was -7.6 percent. Although this group represents only 4.5 percent of household expenditures, its price variations can have a considerable impact on the general index, as these are frequently very sharp. In January of this year, minimum wages increased by 7 percent. This rise had been agreed upon in October of 1993 for the present stage of the PECE, as was a fiscal bonus for workers whose wages are equal to or lower than four minimum wages. Benefits obtained from this bonus are proportionally inverse to the workers' income levels. These two measures resulted in a significant recovery in the real income of those workers with earnings equal to or lower than four minimum wages. I.6 Monetary and Exchange Rate Policy The economic strategy that has been followed since the end of 1987 has stressed reducing inflation. Nevertheless, it should not be inferred that reducing inflation is an end in itself. Rather, it is a necessary although not sufficient condition to achieve more important objectives, such as social justice and higher sustainable economic growth. Both exchange rate and monetary policies have played a major role in the fight against inflation. In accordance with the current exchange rate policy, the daily depreciation of the floatation band's ceiling is 0.0004 new pesos per U.S. dollar, whereas the band's floor has remained unchanged at the level of 3.0512 new pesos per dollar. As of the end of May of this year, the range of the band will widen to 11.1 percent, and as of year's end, it wil1 have widened to 13.9 percent (see Graph 7). The exchange rate regime based on a gradually widening floatation band was adopted in November 1991, in order to achieve a proper balance between two objectives: to help stabilize inflationary expectations, and to achieve greater flexibility in managing balance of payments fluctuations. This is due to the fact that the band provides certainty about the exchange rate's maximum and minimum levels. At the same time, the widening of the band provides flexibility so that exchange rate variations may balance foreign currency supply and demand without frequent intervention by Banco de Mexico in the foreign exchange market. This, in turn, reduces instability in the monetary base. Provided they are not perceived as an upward or downward trend in the value of foreign exchange, exchange rate movements within the band of flotation need not necessarily have an impact on the overall price level. On this there is ample international evidence. Last November's developments in relation to the uncertainty about NAFTAÕs ratification also demonstrate how temporary increases in the exchange rate do not necessarily have an inflationary effect. As for monetary policy, this has always been geared towards preventing an overexpansion of primary credit; otherwise, such expansion would produce undesirable inflationary pressures. With the elimination of reserve requirements and subsequently, of the liquidity ratio for commercial banks, monetary policy is now implemented through government securities purchases and sales and repurchase agreements made by Banco de Mexico in the money market. The amounts of open market operations carried out by Banco de Mexico are determined according to monetary programs which are applicable for specific periods, and updated on a daily basis. These programs are aimed at determining the Central Bank's interventions in the money market, so that variations in the supply of monetary base satisfy, at market interest rates, changes in the expected demand for bills and coins, as well as for the banking system's deposits with Banco de Mexico. This is provided that the resulting money supply is consistent with inflation targets. When this consistency cannot be achieved, Banco de Mexico satisfies the demand for liquidity at interest rates other than market rates. For example, if the growth in the monetary base resulting from an intervention by Banco de Mexico, were excessive to reach its inflationary objectives, the Bank would supply the liquidity required by the system, but at above-market interest rates. It should be kept in mind that in the very short run, the system's demand for liquidity does not react to interest rate movements, owing to the necessity to settle prior payment obligations. Nevertheless, an increase in interest rates would cause further contractions in the demand for monetary base and for credit in general, as well as for goods and services. Thus, the restrictive action of such monetary policy would continue until equilibrium could be reestablished, i.e., until the rate of growth of the monetary base is consistent with the target for inflation. Having described how monetary policy is implemented, this section analyzes its evolution in the first quarter of 1994. During the first months of each year, monetary policy actions undertaken by Banco de Mexico are to a large extent influenced by the seasonal reduction in the demand for bills and coins. In general, the Central Bank responds by selling large amounts of government securities in the open market, in order to absorb excess liquidity. In January-March 1994, Banco de Mexico sterilized a net amount of 4,652 million new pesos. This figure was considerably lower than that of the same period of 1993 (8,148 million new pesos). Nevertheless, this did not imply that the Central Bank left the market with excess liquidity, for the following reasons: (a) In 1994, the sweeping contraction of the bank's deposits with Banco de Mexico was not --nor should it have been-- repeated as in 1993, when the money market's so-called "early sessionÓ (with value date previous day) was introduced. In this session, banks have an additional opportunity to avoid overdraft in their accounts with Banco de Mexico, which allows them to operate with lower balances in these accounts. (b) At the end of March 1994, the demand for bills and coins increased considerably, as Easter Week holidays fell on the last week of March, while in 1993 they were in April. (c) Apart from seasonal factors, the demand for bills and coins has been rising at an increasing rate since September of 1993. This can be explained by the incipient economic recovery and the decline in inflationary expectations. But there are other factors: - On the one hand, it appears that the public is to some degree substituting the use of checks for bills and coins, now that banks are charging higher fees for handling accounts, and now that these accounts have been paying interest rates substantially below those on other investment options. - On the other hand, the amount of bills and coins held by banks has increased substantially in the first months of this year, as they have been offering more extensive automated teller machine services. - There is a perception that fees charged by credit card issuers to affiliated establishments are fostering cash payments, by which customers obtain discounts. - Furthermore, the apparent growth of the informal economy may also imply a greater demand of bills and coins, since transactions are carried out in cash. The validity of this hypothesis and the quantification of the phenomenon cannot be determined, given the difficulties in estimating the magnitude of the informal economy. (d) Finally, in the first quarter of 1993, Banco de Mexico accumulated a substantial amount of international reserves, while in the same period of 1994 this accumulation was relatively modest. When it acquires international reserves, Banco de Mexico automatically creates additional liquidity, which could be excessive, given the demand for monetary base. Thus, when substantial amounts of international assets are accumulated in the Central Bank, as was the case in early 1993, it sells government securities in order to reestablish equilibrium in the money market. It should be noted that during January and until the end of the third week of February 1994, Banco de Mexico accumulated important amounts of international reserves. In effect, in the first two months of the year there were substantial inflows of foreign capital, which to a large extent were acquired by the Central Bank. In order to prevent undesirable inflationary pressures, Banco de Mexico sterilized almost all of the monetary impact of these flows, which resulted in sharp falls in net domestic credit. These capital inflows brought about the continued downward trend in interest rates (see Graph 8), which began in October of 1992, and the maintenance of the interbank exchange rate at the floor of Banco de Mexico's intervention band. In fact, in mid-February of this year, a rarely seen speculative phenomenon took place: a large number of economic agents adopted short positions in foreign currency, in expectation of an appreciation of the peso to the floor of the band. When these agents realized that the adjustment to accommodate the substantial inflow of foreign capital would be effected through interest rate cuts (recall that the 28-day CETES rate reached 8.81 percent at the auction of February 22, 1994) rather than through an appreciation of the peso, they covered their short positions. This reaction, together with developments in international financial markets --substantial interest rate increases on dollar-denominated instruments and sharp falls in the price indexes of the major stock exchanges worldwide, which affected developing countries' securities-- caused an upward trend in the interbank exchange rate and an upward adjustment in interest rates. The rise in the exchange rate and the upward adjustment in interest rates were exacerbated at the end of March, with the tragic assassination of the PRI's presidential candidate. In fact, on March 25, 1994, the interbank exchange rate reached the ceiling of the band and stayed there for nearly a month (see Graph 7). During most of April of this year, the aforementioned instability in domestic financial markets prevailed: the interbank exchange rate remained at the band's ceiling until nearly the end of that month. Nevertheless, the combined effect of exchange rate and interest rate movements has reestablished equilibrium in the financial markets. This made further Central Bank intervention in the foreign exchange market to maintain the exchange rate within the band unnecessary. The simultaneous use of exchange rate adjustments within the floatation band, and of interest rate and international reserves flexibility, has softened the negative effects of turmoil on the international financial markets and of the country's tragic events in recent months. The monetary authorities are aware of the repercussions of sharp interest rate and exchange rate movements on certain sectors of the economy. Nevertheless, should there be a destabilizing factor, and rather than using international reserves, the adjustment fell on only one of these variables, the fluctuations in that variable would be relatively greater, thus having a greater impact on those sectors most sensitive to such fluctuations. On the other hand, if the adjustment were spread across more than one variable, and in consequence among a wider range of economic agents, its effects would surely be more bearable. Following this line of thought, it may be said that if the response to the situation in recent weeks had been exclusively through interest rates, some financial intermediaries, firms and individuals with large peso-denominated liabilities would have suffered a more adverse impact. Similarly, had the adjustment been achieved through sharper increases in the exchange rate, other economic agents, such as those with foreign currency-denominated debts or importers, would have been more seriously affected. It should also be noted that, with the objective of contributing to market adjustment, both Banco de Mexico and the Ministry of Finance facilitated a change in the composition of internal public debt held by investors, by withdrawing a considerable amount of CETES in exchange for Tesobonos. The announcement of the reciprocal credit agreement signed by Canada, the United States and Mexico has also been a very positive element in the stabilization process. With this agreement, there is now an additional instrument to help attain orderly conditions in the North American foreign exchange markets. All together, these measures have reduced the pressures in the financial markets, as demonstrated by the peso's recent appreciation against the dollar, and the slight decline in interest rates over the past weeks. 1.7 Monetary Aggregates During the first three months of 1994, the monetary base contracted by 2,335 million new pesos, after having fallen 9,377 million new pesos in the same period of last year. Nevertheless, from the end of March 1993 to March 1994, this monetary aggregate increased by 29.7 percent. This rate of growth might appear excessive, yet it reflects the circumstances mentioned above, in (a), (b) and (c), on pages 33 to 35. The daily average of the monetary base's annual growth rate, however, fell to 17.3 percent in the first two weeks of May. The growth rate of M1 has also been relative}y high. M1 recorded a 19 percent monthly average growth rate for the first four months of 1994. During the first quarter of 1994, M4 continued to increase at rates that may be considered very high by historical standards in real terms. The annual real rate of growth of M4 during March 1994 was 18.2 percent, while the January and February rates were 15.8 and 18.2 percent, respectively. As for the evolution of M4 during the first quarter of the year, the following comments apply: - The financial system has grown considerably now that credit transactions have become more attractive in the broadest sense. This is the result of an improvement in the regulatory framework which has removed unnecessary barriers to financial intermediation. - Holdings of government securities by the public registered substantial increases in January and February of 1994, as real rates of growth -with respect to the same period of the previous year-- were 33.5 and 45.1 percent, respectively. Such increases are for the most part a reflection of government securities sales by Banco de Mexico during the first two months of the year in order to sterilize the monetary impact of foreign capital inflows. Nevertheless, the dynamism of the trend shown by government securities held by the public suffered marked deceleration during March, when it fell to a 26.7 percent rate of growth. This phenomenon was due in part to purchases of these securities made by Banco de Mexico at the end of March with two objectives: to offset the monetary impact of reductions in international reserves, and to satisfy the seasonal increase in the public's demand for bills and coins for the Easter Week vacation period. The balance of total domestic financing extended by the financial system --which is the main counterpart of M4-- increased by 9.6 percent in real terms during the first quarter of the year, with respect to the same period in 1993. Domestic financing to the non-financial public sector decreased by 26.4 percent in real terms, while real domestic financing for the private sector rose by 17.1 percent. With this, the trend that began in 1989, of a redistribution of financial resources towards the private sector, continued. II. MONETARY POLICY MEASURES Banco de Mexico must decide how to use the monetary policy instruments available to it, in order to attain the rates of inflation it has targeted. As mentioned above, the Bank clearly does not have the power to directly determine the general price level of goods and services in the marketplace. Consequently, the Central Bank must act on certain variables that, in addition to influencing the price level, can be directly affected by monetary policy. These variables are: any of the monetary aggregates, interest rates, and the exchange rate. Nevertheless, no consensus has been arrived at among central bank specialists, particularly in the past, as to whether rigid rules should be adopted for these variables over relatively long periods of time, or whether the central bank should act in a more flexible manner in the face of continually changing conditions. The current trend is for central banks to enjoy the necessary flexibility to act on these variables discretionally. This is because the stable relationship that supposedly exists --according to those who would promote the use of rigid rules-- between these variables and the inflation targets has not been shown to exist. In this respect, it should be kept in mind that the rigid rules more frequently applied in the past were defined in terms of the growth rates of certain monetary aggregates, whether M1 or others. These approaches failed because of the continuously changing nature of monetary aggregates. Non-interest checking accounts are not the same, for instance, as interest-bearing ones. Consequently, the velocity of money in circulation --which establishes the relationship between the amount of money held by the public and the price level, given the size of the real domestic product-- appears to be highly unstable. Graph 9 confirms this for the case of Mexico. In these circumstances, the usefulness of these rules --as defined in terms of monetary aggregates-- is questionable for achieving inflation targets. In view of the above, the Banco de Mexico's Board of Governors has judged it indispensable to retain t1he necessary flexibility in order to determine and, should it be the case, quickly adopt the most appropriate measures to overcome the problems of an environment sensitive to changes that are neither gradual nor foreseeable. Banco de Mexico has been operating under these principles in recent years, with favorable results. Therefore, there appears to be no major reason for the Bank to alter its overall monetary policy guidelines. These are as follows: 1. The adjustment of monetary base supply on a daily basis in order to satisfy the expected demand for monetary base, at market interest rates, provided that the resulting variation of the stock of money does not endanger inflation targets. Once this condition is met, the Bank endeavors to avoid contractions in output. 2. If for any reason, including the appearance of exchange rate pressure, attaining inflation targets is hampered, the Bank continues to satisfy the daily demand for monetary base-- otherwise, the payments system could not perform settlements-- but at above-market interest rates. It should be recalled that, other factors remaining constant, at higher interest rates the demand for goods and services and for foreign currency tends to diminish. Some clarifications may be pertinent regarding these guidelines. Although they take the monetary base as reference, there are no rigid rules for its future behavior, precisely in order to maintain the flexibility to adjust its growth, given different contingencies, without jeopardizing the inflation target. The monetary base is used as the main reference aggregate for monetary policy, as it is the variable that Banco de Mexico is able to directly affect. III. INFLATIONARY TARGETS Banco de Mexico must comply with its constitutional mandate to procure the stability of the national currency's purchasing power as its primary objective. In this respect, the Board of Governors has decided to establish inflation targets for the short, medium and long terms. Thus, economic agents will use these targets as forecasts of future increases in the general price level, which will facilitate the complex task of making decisions that have effects through time. In addition, the Board judges that future reductions in the rate of inflation should not be abrupt in very short periods. Were this the Central BankÕs desire, it would be at the risk of imposing severe adjustments on the real sector of the economy, which could represent extreme costs for some economic agents. The costs of such adjustments would be high in comparison to the benefits that would result from substantially lower inflation in the near future. Short Term Target The Board of Governors believes that the Bank should give all possible cooperation in bringing down inflation, as agreed in the "Pact" of October 1993 and ratified in the document entitled "General Economic Policy Criteria for 1994" (Criterios Generales de Politica Economica para la Iniciativa de Ley de Ingresos y el Proyecto de Presupuesto de Egresos de la Federacion correspondientes a 1994). Medium Term Target The Federal Government, through various reports its officials have made in recent years, has declared its intention to reduce the rate of inflation to levels similar to those prevailing in Mexico's main trading partners. The Board of Governors concurs with this criterion as the medium term target. Long Term Target The constitutional mandate to which Banco de Mexico is subject is not necessarily fulfilled with the achievement of this medium term target. This is due to the fact that it cannot be guaranteed that the rate of inflation in our main trading partners will be reduced to the point where stability of the general price level is attained. Nevertheless, it is this last objective which is in accord with the constitutional mandate. Therefore, domestic inflation should be expected to fall to a level between 0 and 3 percent. According to the international consensus, which can be inferred from studies on price indexes, rates of inflation in this range may be considered to represent general price level stability. This is because indexes over-estimate price increases --as they do not fully account for improvements in quality-- and suffer from other technical problems. The time required to achieve the medium and long term targets will depend to a large degree on the consistency among the various aspects of economic policy, including those for which the Central Bank is responsible. This consistency will also be the determining factor in reducing inflation without imposing unnecessary costs in terms of economic growth.