6 Effectiveness is also severely impaired as domestic financial markets have reached some degree of development and integration with the rest of the world. With hindsight from the current crisis, one can think that rather than controls, what is needed is a prudential regulatory framework to avoid speculation and high risk taking in the banking system. 5. The rise and fall of inflation  In this section I will review inflation behavior in Chile, a country that had the sharpest increase in inflation among emerging economies in the run up of commodity prices, but also the largest decline since the crisis erupted (Figure 3). The most remarkable component of the inflationary process of 2007-2008 was how strongly the increase in international food prices was transmitted domestically. Inflation rose from a y-o-y rate of 2.6% in December 2006 to 9.9% in October 2008. Then, it declined to -1.0% in August 2009. What accounts for the steep rise in inflation? It may partially be due to Chile’s high degree of commercial openness. There are practically no barriers to imports, no widespread protection of agriculture, nor any large-scale distortions in the market pricing mechanism, so changes in external prices are quickly reflected in the domestic market. In fact, at least during the greater part of 2007, growing inflation was mostly caused by increasing food prices, rather than by a widespread inflationary process (Figure 4).
A credible inflation target with a flexible exchange rate regime should help to avoid the problems we faced during the 1990s. Indeed, during the period of large capital inflows, no monetary policy in Latin America operated under a full-fledge inflation targeting regime, and most countries had some form of exchange rate rigidity. Despite having a flexible exchange rate and an inflation target in place, the effects on the exchange rate could reflect that domestic asset prices could be forming a bubble. In this case, sterilized intervention, without an explicit objective on the level of exchange rate, can also help. I already discussed some principles to guide sterilized intervention within an inflation targeting framework. A much debated proposal is the use of capital controls. The  5  In addition, a traditional concern is that with the same speed as capital flows in, capital may flow out, generating costly adjustment processes. See Cowan et al. (2007) for a review of sudden starts and sudden stops around the world. Sudden stops of inflows are as common in developed as in emerging countries, but in the former, the sudden stop tends to be offset by a return of domestic capital invested abroad, while in the latter it results in a severe squeeze in the capital account. Accumulation of reserves or another form of insurance should help to avoid large swings. BIS Review 113/2009  5  evidence on their effectiveness is elusive.