Latin America’s leading central bankers have appealed for help from their finance ministers and highlighted the limits of monetary policy in weathering the severe terms-of-trade shock affecting the region.
The slowdown in China and the end of the commodities super-cycle has led to a big depreciation in Latin American currencies, which is triggering jumps in pass-through inflation.
Central banks face a difficult trade-off between keeping accommodative monetary policies in place to encourage subdued rates of GDP growth and a desire to raise rates to keep inflation expectations anchored. Meanwhile, investors have been trying to predict which Latin American central banks will raise rates despite the economic slowdown.
“Given the nature of this terms-of-trade shock, it would be a mistake to think that central banks should deal with these issues by themselves – we have a lot to do but we need strong fiscal policy and a strong financial system that works with a monetary policy geared to price stability,” says Augustin Carstens, governor of the Bank of Mexico, at the IMF/World Bank meetings in Lima in October.
Mexico’s currency has fallen by 20% in the past 12 months, but inflation remains in check and there has been no FX market intervention.
Meanwhile, the Brazilian real has fallen against the dollar by more than any other major world currency, exacerbating already high inflation (approaching 10%) and the Brazilian central bank has been much more active. The BCB has increased rates to 14.25% and intervened in the FX market by selling swaps to support the currency.
However, Alexandre Tombini, governor of the BCB, agrees with Carstens that a monetary policy solution to the crisis is limited.
“This is not a task for the central bank only,” he says. “We need to have a strong macroeconomic policy framework to weather [the end of the commodity super-cycle]. We have seen a fiscal adjustment, in regards to subsidies in the energy sector and bringing back some environmental taxes and so the price of energy is going up.
“This is good for the fiscal [position] but the adjustment has been at a slower speed than originally thought due to a political [crisis], and that is having an impact on risk premia.”
Rodrigo Vergara, president of the Central Bank of Chile, says the central banks have a joint responsibility to facilitate the economy’s transition away from the domination of commodities.
“The challenge goes way beyond monetary policy to get back on track for growth,” he says. “We are facing tighter financing conditions and an end to the commodity super-cycle and we need to shift resources [via] a real depreciation in the exchange rate.
“In Chile we have allowed the currency to depreciate since 2013 while having a more expansionary monetary policy – despite inflation going up and being above target for the past 18 months.”
Vergara adds: “We don’t like this but it is transitory and we think expectations are well anchored and that’s why monetary policy in the region remains accommodative if not expansionary. Colombia has raised rates but in Chile real short-term rates are significantly negative.”
His assessment appears to contradict the expectations of many economists for rate rises in the region in the near future. For example, Goldman Sachs has predicted two rate rises in Chile, as well as another rise in Colombia and Peru.
The region’s bankers have also downplayed the possible use of macro-prudential measures to deal with the terms of trade shift, in favour of a more orthodox reliance on flexible exchange rates and inflation-targeting regimes.
“We used macro-prudential measures in 2007 and in early 2008 – in that period we used capital controls – everything,” says José Uribe, governor of the Central Bank of Colombia. “This is the only occasion we have used these tools because application should be framed through an analysis of cost versus benefit and adopt them only if there is a strong feeling that the benefit will outweigh the cost of distortions [these tools create in the economy].”
Vergara echoes Uribe’s theoretical acceptance but practical wariness of such policies. “We are prudent about macro-prudential measures,” he says. “We have seen so many curious measures taken in this part of the world and you need to be very clear what the objectives are for the instruments. We ourselves used capital controls in the 1990s but the cost to benefit result is not good in our analysis.”
Vergara adds: “We have to live with volatile capital flows – unless we close our economies.”
In response to Vergara’s thinly veiled criticism of Brazil’s use of capital controls in the wake of the financial crisis in 2009, Tombini says: “We had to deal with unprecedented levels of liquidity in 2009 and 2010, and the [existing] policy framework wasn’t sufficient to deal with these very large inflows.”
He continues: “A lot of money was left in the domestic markets and credit was growing much faster than we wanted. We had to enlarge our toolkit. Capital flow measures are exceptional and temporary and they create their own problems but given the size of the inflows there wasn’t another option.”