What Are the Factors Helping Latin America to Contain Inflation?

Independent monetary policies brought a dual effectiveness in the fight against inflation, with both tightening and the competitive appreciation of local currencies, according to Moody’s

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Bogotá — With the exception of Argentina and Venezuela, Latin American inflation is already in a downward cycle, which is reflected in the fact that most of the region’s large economies reached single digit rates, demonstrating that the restrictive monetary policy “is producing a positive effect” in that battle, according to a report by Moody’s Investors Service.

The report highlights that the achievements in the battle against inflation in Latin America respond, among other factors, to the implementation of floating exchange rate systems by the region’s central banks, which allowed them to pursue an independent monetary policy.

According to Moody’s, this strategy has provided a dual effectiveness in the fight against inflation, which has manifested itself in both monetary tightening and the competitive appreciation of local currencies.

Monetary tightening was “implemented on both the price and quantity sides of the money supply, which acted on the demand pressures generated by the expansion and prolongation of liquidity during the pandemic”, the report states.

This not only raised the cost of credit, “but also limited its availability, and having an effect on decisions regarding consumption and investment”.

The disinflationary process in the region is largely the result of tight monetary conditions and moderation in international prices as global supply chains have returned to greater normalcy.

Moody's

kewise, the competitive appreciation of Latin American currencies has played an essential role in the fight against inflation.

“Although they are not the product of a deliberate policy to affect the exchange rate, these exchange rate appreciations are competitive because they are the result of a specific policy that generates an indirect benefit by inducing downward pressure on prices,” Moody’s said.

This appreciation was triggered by the widening spread of local interest rates compared to those in the United States and Europe.

By raising interest rates at a faster pace than their foreign counterparts, Latin American central banks were able to attract investment into local bond markets, thereby strengthening local currencies and generating downward pressure on domestic prices, the report states.

And since most Latin American countries have flexible exchange rate systems, this has given them that independence in their monetary policies.

Thus, “while monetary restriction acted directly on domestic demand pressures, exchange rate appreciation produced downward pressures on domestic prices by lowering the price of imported products. This together has led to an acceleration in the rate of decline of inflation in most Latin American countries,” the report states.

The post-pandemic period in Latin America was marked by a rise in inflation, which lasted from the end of 2020 to mid-2022, when inflation peaked in most countries.

However, the rectification of monetary policies by central banks allowed for the reversing of this inflationary trend and establishing a disinflation process in the region, according to the report.

Inflation has now begun to move back toward previously established targets.

The consolidation of this inflationary convergence implies that Latin America’s central banks must maintain an attractive rate differential for a sufficient period of time.

Moody’s notes that with the exception of Argentina and Venezuela, where inflation has reached triple-digit rates, four of the region’s largest economies peaked at double-digit rates and the other two have remained in single digits.

Within these six economies, the highest inflationary peak was reached in Chile with an annual rate of 14.1%, followed by Colombia with 13.3%, Brazil with 12.1%, Uruguay with 10%, Peru with 8.8% and Mexico with 8.7%.

Moody’s also recalled that in 2022 some governments took measures to mitigate rising costs, “either by granting monetary transfers or by regulating some key prices such as fuel and basic foodstuffs”.

Moody’s considers that the region must now avoid a sharp reversal of capital flows that “generate depreciatory exchange rate pressures and hinder the convergence and permanence of inflation around its target,” which will imply a gradual monetary easing cycle.