Latin America: Monetary Policy Works

Roberto Melzi and Jimena Zuniga, Barclays Capital, New York.
This article appeared in the May 2009 issue of Current Economics with permission of the author.

Key Concepts: Monetary Policy | GDP Growth |
Key Economies: Latin America |

We challenge the not uncommon notion that monetary policy in the region can do little for growth. Our belief that policy remains effective underscores our view that regional central banks will continue to reduce rates and that growth will be supported in 2010.

As inflation-targeting central banks in Latin America continue to relax monetary conditions, we have noticed some investor concern regarding how much further central banks will be able to cut rates, and how effective those rate cuts will be. Lingering concerns about central banks’ ability to do so may be grounded on years of macroeconomic history that until now had never allowed for a counter-cyclical monetary response. Indeed, in the past, recessions in the region tended to expose widespread lack of confidence in the banking system, eliciting higher rather than lower interest rates, for the sake of financial stability. In some cases, the confidence problem was compounded by balance sheet troubles originating in currency mismatches.

Concerns about the effectiveness of rate cuts, meanwhile, tend to be linked to the limited financial depth in Latin America (Figure 1, below). Moreover, the recent sharp disinflation in the region can take away all the “real” benefits of the interest rate cuts. The collapse in commodity prices and the tightening cycle that was in place prior to the fourth quarter of 2008 shock has helped reduce inflation by 2% on average since its peak.

The scepticism by some participants about the effectiveness of monetary policy in the region may have fed the belief that central banks will not take policy rates to much-lower levels, as rate cuts will not do much for growth. We find little support for this scepticism, consistent with our relatively aggressive monetary policy calls (Figure 2, below), and above-trend 2010 growth forecasts.

Figure 1: Admittedly, relatively low financial depth in Latin America Figure 2: Central banks to continue to ease at a solid pace
Limited financial depth in Latin America Monetary policy easing by Latin American central banks
Source: IMF Global Financial Stability Report, Barclays Capital Source: Barclays Capital

Low Rates Still Matter

We would not dismiss the effectiveness of monetary policy on the grounds that the region’s banking sector is small because that would overlook two key channels of monetary policy transmission. First, lower interest rates cause individuals and firms to alter their spending and investment decisions even if their banking accounts are small.

Second, to the extent that rate cuts can lead to a depreciation of the local currency, monetary policy decisions can boost the competitiveness of exports and import-competing sectors. Although this channel can be powerful in small open economies, its effect in the region may be less clear given some remaining currency mismatches on the region’s corporate balance sheets. In countries such as Peru and Mexico where currency mismatches are non-negligible, the negative balance-sheet effect of depreciations can overwhelm the expansionary effect from trade.

Figure 3: Unscathed money multiplier in Latin America Figure 4: Mexico's inter-bank market relatively undisrupted
Money multiplier in Latin America Interbank rate in Mexico
Source: Haver Analytics, Barclays Capital Source: Barclays Capital

But even if policy can affect growth without a deep banking sector, what is remarkable about the current cycle in Latin America is that the traditional transmission channels of monetary policy through the banking sector appear to be working well. This likely reflects the improved macroeconomic management over the past years, buttressing the credibility of banks.

In particular, there are no signs of disruption in the process of money creation. The monetary multiplier across the region has at worst been stable. As a matter of fact, it was boosted in Brazil by the central bank’s decision to lower reserve requirements by 30% since last September. Reserve-requirement reductions in Colombia last October and Peru since last September also appear to have caused a marginal increase in the multiplier. The situation contrasts with the collapse of the multiplier in the US (Figure 3, above).

Figure 5: Chile, leading the way on aggressive easing Figure 6: Relief in Mexico's commercial paper market
Monetary easing in Chile Interest rates in Mexico
Source: BCCH, Bloomberg, Barclays Capital Source: Banxico, Bloomberg, Barclays Capital

Similarly, there has been little disruption in the inter-bank market during the crisis. Spikes in the overnight inter-bank rate above the central bank target rate, similar to those that occurred in the US, were largely absent in Latin America. The spread between inter-bank rates and government bond yields was comparatively subdued too (Figure 4).

As a result, beyond temporary stress in the fourth quarter of 2008, the dynamics of key lending rates to the Latin American corporate sector have tracked the changes in monetary policy rates since the beginning of the easing cycles. This has been particularly clear in Chile (Figure 5, above), where the central bank has been most aggressive, but also quite remarkable in Mexico (Figure 6, above) and Colombia. Brazil’s less timely reporting possibly conceals a similar improvement.

Beating a Dead Horse

The policy easing over the past few months has been accompanied by a marked reduction in inflation expectations, with the exception of Mexico. However, in general, rate cuts have outpaced the expectations drop, such that real rates have also begun to move down in most economies (Figure 7, below). Moreover, the disinflation process in place in Latin America does not dampen the power of policy: if central banks had not reduced nominal rates, real rates would have actually risen, with economic activity suffering more.

Overall, we think the behaviour of lending rates should be reassuring for central banks, in that the relaxation of monetary conditions is finding its way to economic agents through well-functioning bank transmission channels. If anything, the improvement in inflation expectations suggests that further decisive easing may be required to engineer a more meaningful drop in real rates.

Figure 7: Lending rates in Latin America Figure 8: Lending rates minus inflation expectations
Lending rates in Latin America Real lending rates in Latin America
Source: Central banks, Barclays Capital Source: Barclays Capital

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