Hard-earned gains: Latin America and the Caribbean’s advances in fighting inflation and macro-instability

Most Latin American and Caribbean (LAC) economies today are barely recognizable when compared to their former selves just a generation ago. Although not all countries have managed to rein in economic volatility, most have graduated to delivering an almost “normal” macroeconomic performance. The importance of this achievement cannot be overstated. Not only is macro stability critical to citizen wellbeing, but it is an essential foundation for faster growth and poverty alleviation. Progress can be detected in at least three areas.

First, the pandemic is the second recent major global crisis when LAC has not fared especially worse than average, proving how much more resilient the region has become - a far cry from the crisis-ridden continent of the 1980s.

Second, as a previous Latin American and Caribbean Economic Review documented, since roughly 2004, monetary policy has become more countercyclical, as it is in advanced countries. That is, if the economy was hit by an adverse shock, monetary policy could loosen to “counter” the downturn. By contrast, often in LAC, a fall in terms of trade, for example, would not only depress growth but would require a further depressing rise in interest rates to defend the exchange rate. That is, a monetary policy pushed in the same (procyclical) direction the economy was going.

This was necessary to prevent inflation pass-through, minimize increased pressure on servicing largely foreign-denominated debt, and bolster confidence that the situation was being stabilized. Today, central banks are more able to lean against downturns and attending unemployment, reducing volatility instead of aggravating it.

Finally, LAC have become more “normal” in managing inflation. Although prices are surging in Latin America and the Caribbean, year-on-year inflation is estimated at 9.3 percent in 2022, clearly below previous inflationary outbreaks and indeed lower than most regions.  Strikingly, the region, with the exception of a couple outliers, is below the 9.6 percent of the OECD advanced countries, and far below 13.4 percent for Eastern European countries.

One reason for this is that the region, and particularly Brazil, Chile and Mexico all started tightening monetary policy almost a year earlier than the US Federal Reserve, and raised interest rates more aggressively than in previous episodes. Progress in moderating price rises has led Brazil and Chile to publicly declare that interest rates hikes are paused, and most of the region is expected to meet their declared inflation targets by 2024.

Central banks responded early and aggressively to head of inflation

Keys to fighting inflation and achieving normal macro policy

This improvement in macro-performance and resilience is largely due to reforms implemented over the last 25 years, in response to the raging inflation of the 1970s and 1980s which had led to a deep slump in real incomes and social discontent. Three figure centrally.

1. Stronger institutionalization and professionalization. Finance, monetary and supervisory institutions became more professional and regulation more effective. Often, both central banks and ministries of finance are staffed by economists graduating from the best-regarded universities of the world and LAC economists are full partners in global macroeconomic debates. This has led to both better management, and enhanced credibility.
2. Central Bank independence and inflation targeting. In the 1990s, most central banks were granted political and operational independence to enhance their inflation-fighting powers, and numerous studies have shown this has decreased inflation over time and reduced the incidence of inflationary outbreaks. The adoption of clear inflation targets also enhances predictability. The tension seen with some political authorities today is also “normal” in the sense that the raison d’etre of independence everywhere is precisely to insulate long-term goals of price stability from pressures arising from short-term output concerns or financing fiscal deficits and to create expectations that this is, in fact, the case.
3. Increased armor. Regional authorities have taken steps to armor better against shocks. Foreign-denominated debt has nearly halved since 2004, falling from 60 percent of the total to 35 percent in 2021, while central bank reserves have almost doubled from 12 percent of Growth Domestic Product in 2004 to 20 percent in 2021. Lower foreign exposure and more firepower to defend currencies have significantly reduced the risk of unsustainable currency mismatches that have caused so much trouble in the past.

This is emphatically not to suggest that the region is out of the macroeconomic woods: Inflation is not yet vanquished and may continue to require tight monetary policy to dampen it, and additional rises in US treasury rates will complicate managing debt burdens and fiscal accounts. More profoundly, the Latin American and the Caribbean region needs to move beyond increased resilience to greater dynamism: The forecasted 1.6 percent growth for 2023 and 2.4 percent for 2024 are too meager to alleviate poverty and diffuse social tensions.   

But these are not primarily the result of short-term monetary tightness. They echo the region’s growth in the decade of the 2010s at 2.2 percent while the world grew at 3.2 percent, so this is a problem of decades. Latin America must therefore redouble its efforts to understand the longer-term barriers to its growth, and push through the needed reforms, be they in redressing long unaddressed shortfalls in education quality, lack of competition, underinvestment in infrastructure, or weak innovation systems.

This said, the historically modest rates of inflation, increased resilience to shocks (and relative calmness of international markets), and ability to use monetary policy countercyclically all reflect hard-won increased confidence in the region’s institutions and policies that cannot be taken for granted and which merit energetic defense. The credibility necessary to becoming normal takes decades to earn but can be squandered overnight.