Latin American central banks face dilemma as FX weakness fuels inflation fears
By Rodrigo Campos
NEW YORK, Aug 20 (Reuters) -Having led global central banks in tightening monetary policy following the COVID-19 pandemic, major central banks in Latin America now face a new test to their credibility as pressure grows to ease rates even amid resurgent inflation worries.
Inflation in the region's major economies has stopped falling or even ticked higher, while broad currency weakness is making further interest rate cuts harder to digest on the concern that more price pressures are being imported.
"We’ve now reached a critical juncture and risks are mounting," said Geronimo Mansutti, senior Latam credit analyst at Tellimer, in a client note.
"The worsening inflation expectations, increased volatility in global markets and the recent currency weakness in all LatAm-5 countries but Peru have significantly increased downside risks."
He said reaching inflation targets has become more challenging in Chile, Colombia and Mexico "while putting the progress made in the whole region at risk."
Brazil's central bank, which for months faced pressure from President Luiz Inacio Lula da Silva to cut rates, in late July held borrowing costs steady at 10.5% for a second straight meeting. Its board members say they now see more upside than downside risks to inflation, and a growing chorus of economists predict Brazil could start a rate hiking cycle as soon as September.
Chile held steady, showing greater caution following eight consecutive rate cuts.
Others have stuck to their dovish slant. Colombia's central bank lowered its benchmark interest rate late in July by 50 basis points to 10.75% in its sixth cut since December. Peru shaved off 25 basis points to 5.5% after two meetings on hold.
Meanwhile, a deeply divided Bank of Mexico, which for months had followed the lead of the U.S. Fed in holding off on rate cuts, earlier this month finally lowered its benchmark rate by 25 bps to 10.75%.
Bank of Mexico Governor Victoria Rodriguez told Reuters she expected a recent jump in headline inflation to be short-lived and if that forecast turned out to be valid, further interest rate cuts could be in the cards.
CURRENCY CONCERN
The pressure to lift rates won't recede as traders ended the week fully pricing a 25 basis point cut in next month's Federal Reserve meeting. Prices showed a 25% chance of a 50 bps cut.
Depending on where a country is in its monetary policy cycle, following the Fed in cutting rates may remove any added differential that usually makes investing in Emerging Markets more attractive to investors, and can weaken the currency versus the dollar.
Brazil's real and Mexico's peso are the worst performing currencies among major emerging economies this year against the U.S. dollar as fiscal concerns, as well as political turbulence have weighed on both.
The more hawkish talk from Brazilian central bank policymakers there, along with a greater willingness among investors in recent days to embrace risk, has helped trigger a bounceback, but concerns about spending continue to weigh on sentiment.
Still, the scheduled departure of Brazilian central bank head Roberto Campos Neto, who for months fought off pressure from Lula to cut rates, has left some investors on edge. Campos Neto said last week the bank is committed to easing concern surrounding monetary policy.
"If hiking rates is necessary, we will do it," Campos Neto said Friday. "It's a game of credibility, we need to continue demonstrating coherence."
His likely replacement, monetary policy director Gabriel Galipolo, has also shown a more hawkish tone. Even Lula lately softening his rhetoric.
With volatile expectations about a recession in the United States and the effects of the rate hike in Japan, external conditions have added to the region's uncertainty.
Doubts surrounding the longevity of the well-established "carry trade" that had benefited Mexican and Brazilian currencies played their part.
Yet after the initial concern, Citi data showed Latam received last week a "notable inflow from real money investors" even as they shied away from Asia, Africa, Eastern Europe and the Middle East.
Alejo Czerwonko, chief investment officer for EM in the Americas at UBS Global Wealth Management, said Brazil faces idiosyncratic issues related to spending that could make tighter monetary policy its next move -and the country a regional outlier.
"Nobody would have thought that Latin America would be in a position to lead the world in terms of the monetary policy cycle, to have the guts to hike ahead of the Fed, and maybe more importantly, to have the guts to cut ahead of the curve," he said.
"I do think that Latin America will continue, by and large, to ease monetary policy."
Price inflation across Latam's larger economies https://reut.rs/3YKvrmT
Benchmark interest rates in Latin America https://reut.rs/3Me6BnS
Latam-5 currency performance v. USD https://reut.rs/3X4roAK
Reporting by Rodrigo Campos; Editing by Christian Plumb and Aurora Ellis
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