Inflationary pressures have risen across developed and emerging economies in recent months, triggering market concern. Although in the United States the CPI rose by 5.4% year-on-year in June, the highest rate since 2008, our analysis suggests US inflation will soften in the coming months. In Latin America, the resurgence of inflation has turned central banks increasingly hawkish, with tighter monetary policy in Brazil and Mexico from the historical lows observed during the Covid-19 crisis.
Temporary factors driving inflation
As the weak pandemic-hit data from last spring fall out of the calculations, inflation has naturally increased. The question is whether inflation is rising more than expected. This rise in inflation has prompted central banks in Brazil and Mexico to take action to try to meet their targets and anchor inflation expectations. In Brazil, headline inflation exceeded 8% in May for the first time since 2016 driven by prices of industrial goods and electricity. Hence, the Brazilian central bank (BCB) increased the Selic rate three times bringing it to 4.25% from a historical-low of 2% at the start of 2021.
In Mexico, Banxico, the central bank, issued a hawkish statement after a surprise 25bps rate increase in June after annual CPI data climbed to 6% in May. However, in June the monetary policy committee decided to raise rates for the first time since 2018, sending a mixed message to the market due to the uncertainty over Banxico’s reaction function for the coming months. Markets in Mexico reacted swiftly, with 10-year government local currency bond yields rising above 7% and a strengthening of the Mexican peso against the US dollar. Our model suggests inflation in Brazil and Mexico will decline over the coming months as a result of their swift policy actions.
Better-equipped central banks
The second reason why inflation in the Latam region is expected to remain contained is that central banks are better equipped to fight inflation than they have been historically. During the 1980s it was common for Latin American economies to have fixed exchange rate regimes, pre-announcing the value of the local currency relative to the US dollar. The combination of fixed exchange rate regimes and free capital flows meant countries actively used foreign exchange reserves to maintain domestic currency pegs with the dollar. However, these policies failed once countries faced negative external shocks, forcing them to abandon the pegs and causing a sharp devaluation of the currencies.
Over the last 20 years, the combination of freely-floating currencies, low domestic dollarization, inflation targeting, greater central bank independence, and strict fiscal rules has helped reduce the average inflation rate. This was part of a global trend of declining inflation, rather than something specific to Latin America. Nevertheless, the adoption of flexible exchange rates allowed countries to better absorb external shocks, avoiding direct transmission to the domestic economy, help achieve price stability and navigate periods of market turbulence, such as the global financial crisis in 2008, without large macroeconomic imbalances. The increased credibility gained by central banks in the region over the last decade and their ability to actively use monetary policy tools will help them keep inflation under control now.
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