What’s going on in Latin American and Caribbean economies? Growth keeps falling, but unlike the rest of the world, inflation keeps going up (see Figure 1). In this blog I outline two possible views. Policy choices—and what to expect in 2016 and beyond—may depend on the explanation.
Some argue that advanced economies have entered a phase of secular stagnation (See Larry Summers’ latest blog). Demand has been so low that even zero policy interest rates and massive central bank liquidity injections have failed, so far, to bring growth back to previous levels. The story continues that a feed-back to lower productivity growth has cut estimates of potential growth. Central bankers in the North have considered deflation to be a serious risk and long to bring inflation levels back up to longer term objectives— around 2% in the case of the United States (see minutes of the Federal Reserve December meeting). In that country only recently has the labor market started to tighten and inflation showed any signs of life, such that the Federal Reserve increased its short-term interest rate to just 0.25%. Figure 2 plots IMF forecasts for world growth, illustrating how medium-term growth expectations (estimates of potential growth) have slumped.
No wonder that Latin America and the Caribbean, a region open to trade and affected by the world, has been suffering from falling growth prospects. But in contrast, inflation has been relatively high and rising, and in virtually every country with an inflation targeting regime, has been at or even exceeded the higher edge of the relevant target band. Central bankers across the region have been raising policy rates in order to keep inflation and inflation expectations in check (see Figure 3).
One explanation is a form of secular stagnation but with an additional, external constraint. Stagnation in the North plus a weakening China have caused commodity prices to tumble but unlike advanced economies, many Latin American and Caribbean countries are net commodity exporters. Preventing a large increase in net external liabilities (i.e. more external debt) requires an adjustment in the current account and hence a large real depreciation. In economies with flexible exchange rates, this can be achieved by a depreciation of the nominal exchange rate. But a good proportion of the consumption basket is tradeable, the prices of those goods in domestic currency then rise. And there has been some “pass through” to other prices, boosting inflation and reducing the effective real depreciation. If demand from the North (and China) continues to stagnate and commodity prices continue to weaken, secular stagflation may be with us for some time to come.
A second explanation is more optimistic: the region is in a costly transition. During the commodity boom, those export sectors expanded and higher income allowed the non-tradeable sector, particularly construction, to flourish. As per the logic of Dutch Disease there was a real appreciation and the non-commodity tradeable sector (e.g. manufacturing) suffered— at least in relative terms. Now, a sharp fall in the terms of trade is provoking a reverse transition. The region is poorer, has less to spend on non-tradeables and to avoid a “build up” of external debt, imports are being compressed and non-commodity exports have to grow; a large depreciation is required. But exporting firms cannot expand immediately; finding new markets and hiring new workers takes time. The traditional Dutch Disease adjustment then comes with a substantial increase in unemployment, although Latin America’s large informal sector may provide at least a partial buffer to dampen that malaise. This transition may continue until non-commodity exports can take the place of net commodity earnings forgone.
Turning to policies, if secular stagflation is the explanation the cure is in policies that help stimulate demand and increase productivity. The region responded to the global financial crisis by boosting inflexible fiscal transfers, worsening cyclical fiscal positions and if anything eroding productivity (see The Labyrinth: How can Latin America and the Caribbean Navigate the Global Economy). Now, many countries are being forced to adjust in a pro-cyclical fashion and are cutting more flexible capital spending. But to cure secular stagflation, spending on infrastructure may be precisely the best medicine— boosting demand and enhancing productivity. Governments should find ways to finance more growth-enhancing infrastructure that actually expands fiscal space. As this process may take many years, it will also be important to keep inflation expectations in check.
On the other hand, if we are (just) in a costly transition, boosting non-commodity exports will be the key. There is much to be done in helping start-ups and existing firms to expand and ensuring that the opportunities afforded by more competitive exchange rates are realized. Monetary policy (that tends to target a broad consumer price index) must be closely coordinated with government policies to stimulate exports that may depend on more specific costs. Assuming overall consumer inflation expectations play ball, a somewhat looser monetary policy and a more competitive nominal exchange rate favoring new exports during this transition may be appropriate.
But which perspective is correct? In short, it’s hard to know and it may well be some of both. A good guide to policy in such circumstances is to choose actions that would not make things worse— especially if the preferred interpretation proves to be incorrect. Central banks should worry about inflation and ensure inflation expectations are relatively close to targets in the medium term. This helps maintain the inflation target as a nominal anchor such that the exchange rate can float with nominal devaluations translating into real ones. And governments should ensure medium-term fiscal sustainability. Still, within that general rule, there should be two over-riding objectives. First, maintain or increase infrastructure spending that boosts growth and second assist the non-commodity tradeable sector (such as manufactured goods) as much as possible.
What should we expect for 2016? The region is set for relatively low growth, and low commodity prices are likely here to stay for a while – see Commodity booms and busts: evidence from 1900 to 2015. Regional differences will also become evident. Central America and the Caribbean growth may pick up faster if oil prices remain low and as the United States recovers. Higher US growth will favor Mexico but lower oil prices will force a fiscal adjustment that dampens activity. South America is the area most in danger of either secular stagflation and/or a costly transition. Most countries will focus on fiscal adjustment and relatively tight money to moderate inflation expectations. But the type of fiscal policies will be critical. Public spending must be made as efficient as possible and public investment projects must be carefully selected and executed. Government transfers to assist vulnerable groups should be better targeted; leakage to middle and upper income households should be minimized. And there are also significant risks. In some countries low growth and higher fiscal deficits imply increasing debt ratios. If financing dries up, large current account deficits are potentially very dangerous. Large dollar private sector debts and the links between the non-financial and financial sector should be closely monitored. The global economy remains in troubled waters and how governments in the region react in 2016 may well determine if recent social gains will be preserved or if the specter of economic crisis will once again lead to higher poverty and inequality.