Following the Fed: Latin America

Published by Latin Finance

December 15, 2015

Just because the Federal Reserve will likely raise interest rates for the first time in nine and a half years next week doesn't mean all of Latin America needs to follow suit with tighter monetary policy.

The region is again making international headlines—and not in a good way. Swept by a historic corruption scandal that is landing executives and politicians in jail, Brazil is facing one of its worst economic crises in modern history, including a deep recession and double-digit inflation. Venezuela's morass, with official inflation reaching 100 percent and the economy in shambles, makes Brazil's troubles look tame.

While these are extreme cases, the entire region has been reeling this year as plunging commodity prices and the deterioration of business and consumer sentiment have caused a severe slowdown. Countries like Chile, Colombia, Peru, and Mexico are still growing, but in a weak range of just 2 to 3 percent.

The Fed may raise rates in a scenario of little inflation, but with activity improving and unemployment falling. Latin American countries are also reducing monetary stimulus, but in a very different context. Inflation is in most countries above targets while economic activity is quite weak. It could seem puzzling to see that different economic conditions lead to the same policy prescription.

Most Latin American central banks adhere to some form of inflation targeting regime. The guiding principle is to set interest rates not based on current inflation, but on what officials forecast inflation to be in the future. An inflation forecast below official targets signals weak economic activity and calls for looser monetary policy. Conversely, inflation that is seen climbing too high calls for tighter credit conditions.

Ending Commodity Dependence

Latin America is facing a deteriorating external environment. The decline in terms of trade and the end of the commodity investment boom has dented economic activity. Currencies have weakened significantly in the last couple of years, and this is consistent with the adverse external shock as well as feeble domestic conditions. What economies need to resume growth is to reallocate resources from commodity-producing sectors to other tradable goods sectors.

Rather than trying to stimulate more demand, policymakers need to facilitate the transition away from a strong dependence on commodity exports. Fiscal policy is sharply constrained, since it must grapple with the reality that commodity revenues will be low for a quite a long time, and its scope to stimulate demand is very limited. Monetary policy must accompany this process and, regardless whether some tightening takes place or not, it must still be accommodative. This is also key to maintaining a weak currency.

Indeed, the recent turbulence raises the question of whether higher interest rates are justified at all. The depreciation of the region's currencies is a healthy development that will help them regain competitiveness. At this juncture, it is much better to err on the side of undervaluation. The widespread weakening of currencies across the emerging world indicates that there are fundamental reasons for these developments, and fighting fundamentals again, for example by intervening in the foreign exchange market, is unlikely to succeed. It is also ironic that after so many years worrying about currency wars and too-strong currencies, the concern has reverted in some places.

However, depreciation brings a transitory rise in inflation. Indeed, most of the inflationary outburst in the region can be explained by the direct impact of currency depreciation. Some currencies have depreciated between 15 and 25 percent with respect to the dollar on a yearly basis. A couple of additional points of transitory inflation is normal, and in principle this could be accommodated within the policy horizon.

Second Round Questions

The problem is excessive propagation. Whether the inflationary effects of the depreciation persist depends mostly on how long it takes for "second round" effects to revert and, above all, whether inflationary expectations remain anchored and consistent with the inflation target. This is what has haunted policymakers in the region—tightening to prevent losing credibility while keeping an expansionary stance could be justified. Tightening just to avoid currency depreciation is less tenable. Separating the two rationales is quite difficult, since a normal consequence of tightening is to limit depreciation, but in the current context this effect is small, as the recent experience in Colombia shows.

Current conditions are heterogeneous among Latin America's four big Pacific countries (Chile, Peru, Colombia, and Mexico). Colombia was the last to enter deceleration mode, starting late last year. The depreciation of the Colombian peso with respect to the dollar has been sharp and rapid, reaching more than 80 percent this year. Annual inflation has risen from 3.8 percent early this year to 6.4 percent in November. Consequently, and facing rising inflationary expectations, the authorities have hiked rates by a full percentage point since last September, to 5.5 percent.

At the other end of the spectrum is Mexico. It is the only country that has not tightened monetary policy since the global financial crisis. But also, it is the only country with inflation below the target of 3 percent. Both year-on-year headline and core inflation are below 2.5 percent, their historical minimum. Inflationary expectations have also been stable. There are no indications of persistent rising inflation in the near term and activity is fairly weak.

However, it seems that authorities have undue concerns about the impact on the peso of a looming US monetary tightening. They even changed the schedule of their meetings to one day after the Fed's meetings—a highly unusual move. Perhaps Mexican monetary authorities are not willing to deviate significantly from US monetary policy, and markets are already expecting this, but it is difficult to justify a rate hike in the context of an inflation target.

Loosening Ahead?

In an integrated world, where financial conditions tend to be transmitted around the globe, the exchange rate becomes the adjustment mechanism.

Emerging markets have been used to large fluctuations in their currencies since the global financial crisis erupted. The 'taper tantrum" of 2013, a sharp market reaction to the prospect of an end to Fed bond buying, was an example of market overreaction, but also shows that there is no reason to fear short-run currency fluctuations after they settle.

Tightening monetary policy may have some rationale in the context of inflation targets, more in some countries than others, but there are no clear signals of improving economic activity in the region. It cannot be ruled out that after a timid tightening, towards the end of 2016 monetary policy may revert to a loosening mode.