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The Delicate Balance of Protecting Income While Fighting Inflation

May 11, 2023 by Arturo Galindo - Victoria Nuguer Leave a Comment


With food inflation for a median country in Latin America and the Caribbean running at 14% in 2022, its highest level in 20 years and even core inflation — excluding energy and food — running at 7%, central banks in the region have been compelled to keep interest rates aloft. This has contributed to an important social goal because the poor spend the largest share of their income on goods and services and inflation harms them the most.

But this effort to fight inflation and protect the poor requires a delicate balancing act. High interest rates imposed by central banks have successfully cut inflation in many countries. At the same time, they have a dampening effect on investment and consumption and, by slowing the economy, can reduce employment. In countries with high informality, like those of Latin America and the Caribbean, they also may cut the income of informal workers — many of them poor — more than that of formal ones because informal workers are unprotected by minimum wages and contract negotiations that formal workers enjoy.  

The Double-Edged Nature of the Inflation Fight

The fight against inflation can thus cut both ways, lowering prices for the poor while also, in the short run, jeopardizing their incomes and job security. This creates a tremendous challenge in mitigating inflation’s impact, one plumbed in the fourth chapter of the recently released 2023 Latin American and the Caribbean Macroeconomic Report.

To start with, governments must be exceedingly careful in wage negotiations. In Latin America and the Caribbean, wages in the formal sector are strongly indexed to past inflation, creating a vicious cycle in which wage hikes perpetuate, rather than simply compensate for price increases. Excessive salary hikes in this scenario may harm  jobs if  inflation falls and real wages are more than employers are willing to pay. For that reason, wages negotiated on the basis of expected, rather than past, inflation not only help keep prices under control but may also protect employment in the formal sector.

RES-download-IDB-Macroeconomic-Report

In the meantime, carefully targeted energy and food subsidies can mitigate some of the pain for the neediest and most vulnerable. Investment in infrastructure, ranging from roads to digital innovations that link them to goods and services, may boost their income. Evidence shows, after all, that better infrastructure and greater efficiency benefit the poorest people the most.    

The Need for Labor Market Reforms

Reforms to improve the functioning of labor markets and reduce informality are crucial. Companies during difficult economic times are often reluctant to hire workers because of costly obligations,  including health insurance, and pension and severance payments. Workers may also choose to work informally because formal companies deduct the cost of meeting those obligations from their salaries. If regulations were eased, however, and workers had access to types of universal insurance that paid for their health needs and pensions whether they were employed or not, companies might be more willing to hire workers and workers more willing to work in the formal sector, with all the accruing benefits of higher wages, job stability and career advancement.

Other policies would also help workers,  including those that focus on the creation of new firms and of job search systems and databases that allow potential employers and employees to easily find each other.

Reversing the Deterioration in Social Indicators

The first 15 years of the 21st century generated impressive gains in the fight against poverty and inequality in Latin America and the Caribbean. But those positive indicators began to revert in subsequent years due to stagnating growth and deteriorated even further as a result of the COVID-19 pandemic. While the economic recovery of the last two years has returned poverty numbers to their pre-COVID trends, the region is still on a deteriorating path in leading social indicators, and the slow GDP growth of 1% expected for this year is unlikely to give them much of a boost. Still, there is reason for optimism if the right policies are put in place. If inflation can be brought under control, subsides effectively targeted to the poor, and conditions set to improve labor markets, much suffering can be alleviated until better worldwide economic conditions lay the groundwork for renewed growth and wellbeing.


Filed Under: Macroeconomics and Finance Tagged With: #Inflation

Arturo Galindo

Arturo José Galindo Andrade is a Principal Economist at the Research Department of the Inter-American Development Bank (IDB) in Washington DC. Prior to joining the Research Department in 2021 he was a member of the Board of Directors of the Central Bank of Colombia. Arturo has also been a researcher at Fedesarrollo a Colombian think tank, Chief of the Strategic Planning and Monitoring Division at the IDB, Chief of the Strategic Development Division and Regional Economic Advisor for the Andean Region at the same institution. Previous roles include Chief Economic Advisor of the Banking Association of Colombia, Advisor to the Ministry of Finance, Advisor to the Government of Colombia on Coffee Affairs, Professor of Economics at Universidad de los Andes in Bogotá, Colombia, Research Economist at the IDB, and Economist at the Central Bank of Colombia. Arturo holds a PhD in Economics from the University of Illinois at Urbana-Champaign. His academic research includes macroeconomics, monetary policy, financial economics, banking, development banking, public finance, international economics and development economics—fields in which he has published extensively.

Victoria Nuguer

Victoria Nuguer is a Research Economist in the Inter-American Development Bank’s Research Department. She holds a Ph.D. from École Polytechnique Fédéral de Lausanne in Switzerland and a bachelor’s degree from the Universidad de Buenos Aires in Argentina. Prior to joining the Bank in May 2017, she spent nearly three years as a Research Economist in the Bank of Mexico. Victoria’s main research agenda focuses on building dynamic stochastic general equilibrium models to explain key financial transmission mechanisms in closed and open economies. For closed economies, she has focused on the propagation of financial shocks from the housing sector to the rest of the economy. Regarding open economies, Victoria has studied the international transmission of financial shocks from advanced to emerging economies through the bank lending channel. Recently, she has been working on understanding the strategic interaction between monetary and macroprudential policies and on the role of trade credit when firms set prices in emerging economies.

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