Inflation is back. The old scourge has returned to Latin America once more, as the region’s economies – having rebounded sharply from the global crisis – have begun to show signs of overheating amid surging capital inflows and rising global commodity prices.
Consumer prices are rising steadily in Brazil, Mexico, Colombia and Peru, while double-digit inflation is now entrenched in Venezuela and Argentina. Inflation is now tracking above central bank targets across most of the region’s major economies, even though it’s within the upper limit of central bank target ranges. And economists warn that countries could now start to see inflation – until now largely driven by food and energy prices – seep into the core.
“Inflation is a problem in 2011 and is likely to be more of a problem in the coming months than it is today,” says Guillermo Mondino, chief Latin American economist at Barclays Capital. “Countries have been rapidly closing their output gaps, and they’re now either fully closed or are very close to being so. This requires a concerted policy response from central banks.”
The surge in prices is down to a cost-push commodity price shock combined with demand-pull pressures, the result of excess liquidity from the post-crisis fiscal stimulus and commodity-fuelled inflows, says Alberto Ramos, chief Latin American economist at Goldman Sachs. Central banks have been wary to move on rates given uncertainties in the global economy. “Because the global recovery is still tentative, policymakers faced with the choice of being ahead, on or behind the curve may choose to be a bit cautious,” says Ramos.
QUESTION OF CONTROL
Until recently, policymakers have plumped for so-called macro-prudential measures and capital controls over rate hikes that may have aggravated inflows and currency appreciation. Debate has raged over the efficacy of such measures – including Brazil’s taxes on capital inflows and mandatory reserve requirements for foreign investors. But this also threw up worries that central banks were losing their inflation-fighting credentials.
“The fact that many emerging market central banks, including Brazil, appear to be moving away from inflation targeting as their number-one priority is a negative trend,” says David Lubin, head of emerging market economics at Citigroup. “Inflation targeting is key to controlling inflation expectations. If you lose control of expectations, you lose control of your inflation-fighting credibility.”
Adds Barcap’s Mondino: “Brazil’s central bank has been on the conservative side in hiking rates, and there’s a risk of falling behind the curve compared to where Latin American central banks would historically have been at this juncture.”
But recently, a reversal of capital inflows might have made central bankers more willing to countenance interest rate rises. According to data from global fund tracker EPFR, net bond and equity outflows from Latin America totalled $3.1 billion between December 30 and March 16.
It is perhaps no coincidence that Chile, Brazil, Peru and Colombia have all announced further interest rate hikes so far this month.
“Earlier in the year, central bankers were afraid of raising rates because of capital inflows. But now they have the space they need,” says Liliana Rojas-Suarez, senior fellow at the Center for Global Development and former chief economist at Deutsche Bank. She points out that an outflow of excess capital has provided “a window of opportunity to increase rates” quickly. “They’re doing the right thing. They’re using the window.”
OVERSTATING RISK
A consensus is now emerging that policymakers – with the notable exceptions of Venezuela and Argentina – are broadly in control of inflation expectations and that tightening measures will not overturn regional growth. Moreover, analysts don’t expect prices to rise as much as during the previous peak in 2007–8, never mind the double-digit spikes during the 1980s and 1990s.
“We will have some inflationary pressure this year, but not enough inflation that forces a policy response that derails the recovery,” says Gray Newman, managing director and senior Latin American director at Morgan Stanley. “I used to live in Latin America in the 1980s and 1990s; I’ve lived inflation, and this is no comparison. Policymakers need to respond to maintain their credibility, but 5–6% are not the kind of numbers that used to keep us up at night.”
Persio Arida, managing partner of Brazilian investment bank BTG Pactual and former Brazilian central bank governor, tells Emerging Markets that fears about Brazilian inflation are “not justified”, as the country still bears the “scars of inflation in the social memory”.
“It would be political suicide for any president to allow inflation to exceed the target limit – unless you have a major global disruption. The government has all the right incentives to cool off the economy,” he adds.
That Latin America now appears better equipped to withstand potential inflation spirals is, to a large extent, down to the bitter legacy of decades of destructive inflation. Julio Velarde, Peruvian central bank governor, says that most regional policymakers have learnt the lessons of decades of high inflation; a long-standing focus on inflation fighting largely explains why the region is now better equipped to withstand potential inflationary shocks.
“A large number of countries in the region have learned from the past and now have sensible policies and keep a keen eye focused on inflation,” he tells Emerging Markets. “We have improved debt profiles and the majority of countries now have low inflation rates.”
The glaring exceptions to the benign regional norm are Venezuela and Argentina, two nations beset by double-digit inflation. Central banks in both countries are relaxing policy, aggravating an already fragile situation.
“Policymakers in Venezuela and Argentina see the curve coming, but they’re accelerating not braking,” says BarCap’s Mondino. “We need an urgent change in policy in these two countries to bring some balance back to the external accounts of the country.”
IN THE LONG RUN
Despite the well-received achievements of the region’s central banks in recent months, concern is fast growing over broader policy frameworks across the region. In particular, analysts point to a continued failure on the part of governments to undertake tough fiscal action; without it, policymakers risk fuelling longer-term structural inflation which could in turn mean an eventually sharp rise in interest rates – a scenario which could torpedo regional growth.
“It doesn’t make sense to me that countries are laying all responsibility for tightening at the central bank’s door,” says Alberto Bernal, head of emerging markets macroeconomic strategy at Bulltick Capital Markets.“This overreliance on monetary policy could cause a much stronger than hoped for deceleration of investment in the longer term if interest rates go up fast. It’s much better to control public spending rather than crowding out private-sector investment.”
Given the region’s heavy reliance on commodity exports, historically higher commodity prices are also likely to add to structural inflationary pressures; capital inflows are likely to pick up once again over the longer term given the continued prospect of high returns in the region. So although inflation for now may be under control, the potential for longer-term structural inflation remains acute.
Gray Newman believes that such structural problems make up the real challenge for the region’s policymakers. “The root of the inflation problem is that demand is growing too fast, and the lack of a counter-cyclical fiscal policy response has added fuel to the fire,” he says. “I don’t think policymakers are addressing the long-term issues.