As inflation surged in 2021, central banks in Latin America and the Caribbean acted swiftly and aggressively—well before the developed world—to combat inflation by raising interest rates. With inflation largely tamed, they now face considerable pressure to lower interest rates to foster economic growth and ease the burden of debt servicing. But doing so comes with significant risks that could destabilize recent gains in economic stability.
The problem is that with inflation in the United States at 3.5% in March of 2024, interest rates there may well remain higher for longer, meaning that the US is unlikely to accompany Latin American and Caribbean central banks in lowering interest rates, implying that interest rate differentials against the US will be reduced.
A Challenge for Monetary Policy
This amounts to a significant monetary-policy challenge for Latin America and the Caribbean. When interest rates in emerging markets are lowered at a different rhythm from those in the developed world, those emerging markets may well face capital outflows. Investors continually seek the highest returns, and a reduction in interest rate differentials can make local assets less attractive than those in other regions.
Capital outflows are also linked to exchange rate depreciation. And if markets perceive that exchange rate depreciation poses an increased risk to debt sustainability, that could exacerbate a run, particularly in countries that have increased debt levels in the aftermath of the COVID-19 crisis and are more dollarized in their liabilities.
It is not clear at this juncture how sensitive capital flows will be to lower interest rates in Latin America and the Caribbean. But a forthcoming article by the Bank for International Settlements (BIS) suggests that interest rate differentials in Latin America and the Caribbean have a large influence on capital flows at risk, implying that a large reduction in these differentials could have an important impact on capital outflows. Moreover, depreciation could also be substantial, and, depending on the degree of pass-through from exchange rates to domestic prices, inflation could come back to haunt central banks.
Determining the Speed of Policy Rate Reductions
Central banks in Latin America and the Caribbean thus face a fundamental question: should policy rates be reduced swiftly—as many Treasuries are demanding—or at a slower pace?
Part of this question can be answered by examining the mirror-image, e.g., the behavior of capital flows and exchange rates during the region’s monetary tightening phase when interest rate differentials increased dramatically vis-à-vis the United States. Recent estimates suggest that during this cycle, there were large capital inflows and large exchange rate appreciation. Indeed, the correlation between capital flows and exchange rates was considerable during this episode, as high as -0.742 in some countries. Large exchange rate appreciation particularly affected many inflation-targeting economies in the region: from peak to trough, exchange rates appreciated 24% in Costa Rica, 23.1% in Colombia, 19.3% in Mexico, 18.6% in Chile, and 15.4% in Uruguay. This appreciation helped partially to contain inflation. But with interest rate differentials reduced, the opposite dynamics may come into play.
Another element to consider is the size of interest rate reductions needed during this easing phase of the monetary cycle. Monetary policy rates reached highs of 13.75% in Brazil, 13.25% in Colombia, and 11.25% in Chile, to name just a few countries, well above pre-crisis levels. Taking pre-COVID-19 policy rates as a benchmark to which central banks may want to return, the size of potential cuts relative to their interest peaks would be as high as 950 basis points (bps) in Chile, 925bps in Brazil, and 900bps in Colombia.
There have been aggressive cuts in the past that defied market expectations, but they departed from much lower levels. The size of interest rate cuts could thus be much larger this time, and there would be much more at stake in terms of the potential effects on capital flows and exchange rate depreciation. That would be particularly relevant to the extent that carry trade was part of exchange rate appreciation in the monetary tightening phase, as it could easily unwind. The fact that portfolio investment and financial derivatives have been some of the main drivers of capital flows in many countries leaves some room for speculation that carry trade may have been relevant.
Given these challenges, central banks are likely to adopt a cautious approach, reducing rates gradually while closely monitoring their economic impact. So far, monetary easing has been successful, without any major disruption in capital flows. But periods of large fluctuations in interest rate differentials when cycles are not necessarily coordinated with those of developed markets should be closely watched, as they may lead to financial turmoil, or even sudden stops in capital flows.
The dangers are far from insignificant. Two of the main drivers of the probability of a sudden stop—current account deficits and overall fiscal balances—remain larger for the average country in Latin America and the Caribbean than those observed on the eve of previous crises, such as the Great Recession of 2008 or the COVID-19 crisis of 2020. As a result, there is greater risk of financial turmoil in the region. International reserves as a share of GDP—the main buffer against this type of vulnerability—are larger than right before the Great Recession. But they are smaller than on the eve of the COVID-19 crisis. Moreover, this time the United States is unlikely to engage in quick monetary easing if the problem arises in Emerging Markets. That means there may not be a lender of last resort available, as was implicitly the case during the COVID-19 crisis.
Supportive Fiscal Policies
Given these concerns, supportive fiscal policies could be crucial. Robust fiscal frameworks and continued efforts towards fiscal consolidation can reduce country risk. They can provide the necessary stability as interest rates are lowered. The region has done a good job in unwinding primary deficits which, on average, stood at 4.8% of GDP in 2020. These have largely been brought down to balance, but higher interest payments have kept overall deficits in the neighborhood of 3% of GDP, a similar level to that immediately before the COVID-19 crisis. Further consolidation is needed. Lowering interest rates in Latin America and the Caribbean is a complex but necessary undertaking. While the potential benefits are significant, including stimulated economic growth and reduced debt servicing costs, the risks of capital outflows, exchange rate depreciation, and rising inflation represent substantial challenges. As such, a balanced and cautious approach, coupled with robust fiscal policies, could be essential to walking this monetary tightrope without sacrificing the hard-won gains in economic stability.
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