A step ahead: the success of monetary policy making in Latin America

Central banks in Latin America are poised to start cutting interest rates. Early tightening in 2021 helped moderate the inflation outlook. Policymakers will soon seek to accommodate a soft-landing. Those that raised quickest and firmest are ahead of the curve. Disinflation and more stable FX should ease pressure on insurers' claim costs, which, with the still higher rates expected to prevail over the longer term, could boost industry profitability.

• Policymakers in Latin America have made good progress on disinflation.
• However, core inflation is proving more persistent than headline, and hence the current central bank approach is "wait and see".
• Even so, we expect interest rates in the region will start coming down soon, well before the same happens in advanced markets.
• Countries that responded quickest and firmest to the inflation crisis starting in 2021 have first-mover advantage and more scope to cut.
• The growth outlook for Latin America is more positive than for advanced markets, but less so than for emerging Asia, where inflation and rates never spiked up as high.
• Disinflation, more stable FX rates, and higher equilibrium interest rates should support insurer earnings.

It could be said that central banks in Latin America have done a good (so far) monetary policy job with respect to the recent inflation crisis. Many countries in the region are already in disinflation mode, and we expect central banks there to start to cutting interest rates soon, well before their advanced market peers do. The "success" on inflation resulted from early and some of the sharpest monetary tightening in the world in 2021, with rates going as high as 13.75% in Brazil, 13.25% in Colombia and 11.25% in Mexico. That helped better contain inflation than in the euro area, although the annual pace in Latin America currently remains higher (see Figure 1). Inflation in the US and Latin America are both heading south, while Latin America policy seems to be a step ahead, with the gap to core inflation target (2x) less than in the US (2.4x).

Figure 1: Annual core inflation

Further, net capital inflows were attracted by high real interest rates, and many the region's currencies have outperformed globally. Currency strength has meant lower import prices and these, in turn, have also contributed to easing inflation pressures. More weight to the policy success narrative comes from a milder-than-anticipated regional growth slowdown in 2023, with economies like in Brazil and Mexico starting to show the markings of a soft-landing. Note, however, while the growth story is favourable relative to the advanced markets, it is less so versus emerging Asia, where inflation and rates never reached the same heights (see Figure 2).

Figure 2: Growth and inflation historical comparison vs current outlook (Latin America in blue; emerging Asia in green). 

Falls in food and energy prices have contributed most to slowing headline inflation in Latin America. However, in the region's five largest markets, core price rises have also slowed notably in the past four months. For example, core CPI in Mexico have been at their lowest since November 2020 in each of the last three months, with June marking the fifth consecutive month of disinflation. And in Colombia, after a second wave of rising prices earlier this year, core CPI is now pacing at its lowest month-over-month rate since the end of 2021, and the last three months have all been ones of disinflation. Even so, we forecast that headline inflation will remain above the upper limit of the central bank's target range until around 3Q24. In Brazil, annual inflation (3.2% as of June) is already below the central point (3.25%, +/- 1.5%). However, we see a rise to about 5% by the year-end due to the reimposition of taxes measures that were cut and reduced price levels in 3Q22.

Several factors contributed to pushing inflation in Latin America so high: 1) the sudden lifting of COVID-19 mobility restrictions led to a strong recovery in domestic demand; 2) the generous fiscal spending during the pandemic; 3) severe droughts that affected food prices and hydroelectric energy prices locally; 4) supply chain bottlenecks and the war in Ukraine leading to higher prices for goods and commodities, and (5) the habitual practice of wage indexation as a lesson learned from previous episodes of high inflation.

While we expect central banks in Latin America will start cutting interest rates soon, at present the approach is wait-and-see with core inflation proving stickier than headline (see Figure 2). Policymakers are also watching the Federal Reserve's forward-looking statements. Diverging from Fed policy stance more than necessary would mean extra pressure on local currencies and risk import inflation. Those central banks that raised quickest and firmest in 2021 are ahead of the curve and have more space to cut. Hence, we expect to see rates cuts in Chile starting this month, followed by Brazil and Peru in August. The central bank in Colombia, which was slower to react to the inflation spoke, will probably have to wait longer. Mexico is perhaps the most constrained in its ability to cut rates as it cannot afford to deviate from the US stance given the interconnectedness of the two economies.

The success of monetary policy actions to date should support macro stability in Latin America. There were significant increases in inflation and policy rates, but long-dated yields did not increase by as much. That said, we expect the growth differential against the broader emerging market aggregate to remain negative, as many countries in the region still face structural ailments such as high levels of indebtedness, low productivity, political & social instability, and aging populations. For now, momentum suggests growth in the region will accelerate in 2024. A dampening of inflation pressures and a more stable FX rate should help moderate insurance claims costs. This, and what we expect will be still-elevated rates in relative terms over the long term, will boost industry earnings.