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INFOCUS
M AC RO COM M E N T
JULY 2021
The return of
inflation hawks in
Latin America
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of our clients. ASSET ALLOCATION CONSTRUCTIONTHE RETURN OF INFLATION HAWKS IN LATIN AMERICA
Since the start of 2021 inflation has picked-up across both developed and emerging
economies. In Latin America, central banks have turned increasingly hawkish, tightening
policy rates. In this issue of Infocus, Joaquin Thul analyses the prospects for inflation in
the region and why central banks are better prepared to deal with it than before.
Inflationary pressures have risen across developed and 2. CPI inflation rates in US and Latin America, % change year-on-year
emerging economies in recent months, triggering market
7
concern. Although in the United States the CPI rose by 5.4% 2a. UNITED STATES
year-on-year in June, the highest rate since 2008, our analysis 6
suggests US inflation will soften in the coming months.1 In 5
Latin America, the resurgence of inflation has turned central
4
banks increasingly hawkish, with tighter monetary policy in %
Brazil and Mexico from the historical lows observed during the 3
Covid-19 crisis ( see Figure 1). 2
1
1. Monetary policy rates in Latin America
0
16 J F M A M J J A S O N D J F M A M J J A S O N D
2020 2021
14 Actual 80% 60% 40% 20%
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
12
10
10
% 8 2b. BRAZIL
6 8
4
6
2 %
0 4
2016 2017 2018 2019 2020 2021
Brazil Mexico Colombia Chile Peru
2
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
0
J F M A M J J A S O N D J F M A M J J A S O N D
However, the increase in inflation in Latin America is likely due 2020 2021
to temporary factors and the weakness of aggregate demand Actual 80% 60% 40% 20%
suggests it will be short-lived. In addition, and in contrast with Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
previous episodes of rising inflation in the region, the central
7
banks are on this occasion better equipped to tackle it with 2c. MEXICO
more policy tools and higher credibility. 6
5
Temporary factors driving inflation
4
As the weak pandemic-hit data from last spring fall out of the %
calculations, inflation has naturally increased. The question is 3
whether inflation is rising more than expected. 2
1
To determine whether inflation is unexpectedly strong, we
0
estimate a model on data ending in December 2020 from J F M A M J J A S O N D J F M A M J J A S O N D
2020 2021
Brazil, Mexico, Chile, Colombia and Peru and in the US, and
Actual 80% 60% 40% 20%
use it to provide forecasts for 2021. The resultant ‘fan charts’ Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
show the range of inflation outcomes that are compatible with
Cont.
the model (see Figure 2).2 The likelihood of being within the
1
For more information see EFG Infocus, ‘How worried should we be about US inflation?, June 2021.
2
Fan charts are constructed to show the likelihood that actual inflation falls within the different coloured areas with a probability of 80%, 60%, 40% and 20%.
2 | July 2021THE RETURN OF INFLATION HAWKS IN LATIN AMERICA
2. (cont.) This rise in inflation has prompted central banks in Brazil and
7 Mexico to take action to try to meet their targets and anchor
2d. CHILE inflation expectations. In Brazil, headline inflation exceeded
6
8% in May for the first time since 2016 driven by prices of
5 industrial goods and electricity. Hence, the Brazilian central
4 bank (BCB) increased the Selic rate three times bringing it
to 4.25% from a historical-low of 2% at the start of 2021. The
%
3
minutes of the last monetary policy meeting showed the BCB
2
is committed to do “whatever it takes” to bring inflation down
1 to the 3.50% target in 2022.
0
J F M A M J J A S O N D J
2020
F M A M J J
2021
A S O N D In Mexico, Banxico, the central bank, issued a hawkish
Actual 80% 60% 40% 20% statement after a surprise 25bps rate increase in June after
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021. annual CPI data climbed to 6% in May. In its last Quarterly
Inflation Report, Banxico acknowledged inflation was running
7
2e. COLOMBIA ahead of their forecast, but that they expect it to slow towards
6
their target. However, in June the monetary policy committee
5 decided to raise rates for the first time since 2018, sending
4
a mixed message to the market due to the uncertainty over
%
Banxico’s reaction function for the coming months. Markets
3
in Mexico reacted swiftly, with 10-year government local
2 currency bond yields rising above 7% and a strengthening of
1 the Mexican peso against the US dollar (Figure 3). Our model
suggests inflation in Brazil and Mexico will decline over the
0
J F M A M J J A S O N D J F M A M J J A S O N D coming months as a result of their swift policy actions (see
2020 2021
Actual 80% 60% 40% 20%
(Figures 2a, 2b and 2c).
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
3. Reaction of Mexican assets to central bank surprise hike
7 22.0 7.5
2f. PERU
6
21.5 7.0
5
4 21.0 6.5
MXN/USD
%
%
3
20.5 6.0
2
20.0 5.5
1
0 19.5 5.0
J F M A M J J A S O N D J F M A M J J A S O N D Jan Feb Mar Apr May Jun Jul
2020 2021 2021
Actual 80% 60% 40% 20% MXN/USD 10-year government bond yield (rh axis)
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021. Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
In the Andean region, inflation has risen but remains below
fan is 80%. Thus, if inflation stays in the fan, we conclude that it pre-pandemic levels; nonetheless, central banks have become
behaves as expected. If it is above the fan, however, then that is more hawkish.
evidence that inflation pressures are unexpectedly strong.
In Chile, inflation rose above the 3% target in April for the first
The figures show that the rise in inflation in the US, Brazil, time since April 2020 and it remained above 3% in May and
Mexico and Colombia is stronger than one would have expected, June. This led the central bank (CBC3) to hike rates by 25bps to
given its decline last year. 0.75% in July. Data shows a pick-up in activity in May, with the
1
Comparing the deficit ratios is a rough approximation of the size of resources deployed to mitigate the pandemic; a more accurate comparison should relate
the expenditure incurred to the decline in GDP.
3
Banco Central de Chile
July 2021 | 3THE RETURN OF INFLATION HAWKS IN LATIN AMERICA
CBC Economic Activity Index returning to pre-pandemic levels 5. Output gaps in Latin America
(See Figure 4). 6
Forecast
4
Chile has delivered one of the fastest vaccination campaigns
2
against Covid-19 in Latin America, with over 55% of the
0
population already fully vaccinated. This is expected to
allow the economy to reopen quickly, boosting demand. The % -2
combination of strong activity and rising inflation led the CBC -4
to adopt a more hawkish stance in recent months. Our model -6
suggests inflation might pick-up in Chile (See Figure 2d). -8
-10
4. Chile: Economic activity and inflation 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Brazil Mexico Colombia Chile Peru
120 7
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
115 6
110 5 accommodation, weak domestic demand and a negative
%, year-on-year
105 4 output gap are likely to reduce inflationary pressures in the
Index
coming months (see Figure 5).
100 3
95 2
Better-equipped central banks
90 1 The second reason why inflation in the Latam region is
85 0
expected to remain contained is that central banks are better
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 equipped to fight inflation than they have been historically.
Economic Activity Index CPI (rh axis) Inflation target During the 1980s it was common for Latin American economies
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021. to have fixed exchange rate regimes, pre-announcing the
value of the local currency relative to the US dollar. The
Colombia faces the most complex scenario. Over the last two combination of fixed exchange rate regimes and free capital
months its sovereign rating was downgraded by both S&P and flows meant countries actively used foreign exchange reserves
Fitch, reflecting weakening macroeconomic fundamentals and to maintain domestic currency pegs with the dollar. However,
reduced confidence in the government’s ability to pass tax these policies failed once countries faced negative external
reforms. The central bank (BanRep) delivered seven rate cuts shocks, forcing them to abandon the pegs and causing a sharp
in 2020, reducing the policy rate by 250bps to 1.75%. Although devaluation of the currencies.
it still has some space to provide further monetary support,
headline inflation has recently picked-up more than expected The devaluation of the Mexican peso in December 1994
although, according to our model, will soften by the end of triggered a spill-over effect to other emerging economies,
2021 (Figure 2e). Over the last two months, driven mostly by resulting in large capital flight from the region. The effects of
food prices, annual inflation increased from 1.95% in April to the so-called ‘Tequila Crisis’ triggered a change in monetary
3.63% in June. Risking being caught behind the curve, BanRep policy in Latin America, as most central banks abandoned fixed
is likely to adopt a more hawkish tone to prevent inflation exchange rate regimes in favour of more flexible frameworks.
expectations getting too high. Central banks in Chile, Peru and Colombia benefited from the
adoption of inflation targeting regimes in the 1990s, which
Finally, in Peru Pedro Castillo awaits official announcement allowed monetary policy to focus on achieving low and less
of his victory in the Presidential elections. In recent days volatile inflation. In Brazil, the BCB decided to float the real in
he committed to maintain the autonomy of the central 1999 and adopt an inflation targeting regime.
bank (BCRP) and its inflation targeting regime. Inflation in
Peru picked-up to 3.3% in June, forcing the BCRP to increase Over the last 20 years, the combination of freely-floating
its 2021 inflation projection from 2% to 3%. Last year, the currencies, low domestic dollarization, inflation targeting,
BCRP cut the policy rate by 200bps to a record low of 0.25% greater central bank independence, and strict fiscal rules has
to provide monetary support during the Covid-19 crisis. helped reduce the average inflation rate of these five countries
Although the central bank has no space for further monetary from over 300% in the 1990s to 4% in the 2000s (See Figure 6).
4 | July 2021THE RETURN OF INFLATION HAWKS IN LATIN AMERICA
This was part of a global trend of declining inflation, rather headwinds for the recovery in 2021 and, following the decline
than something specific to Latin America. Nevertheless, the in GDP in 2020, negative output gaps will keep inflation at bay
adoption of flexible exchange rates allowed countries to better in the near term. Additionally, inflation targeting regimes in
absorb external shocks, avoiding direct transmission to the place since the late 90s, create a more benign environment for
domestic economy, help achieve price stability and navigate inflation in most of the region.
periods of market turbulence, such as the global financial
crisis in 2008, without large macroeconomic imbalances. The Central banks in LatAm will want to prevent inflation rising
increased credibility gained by central banks in the region significantly above target and will act swiftly to contain short
over the last decade and their ability to actively use monetary term expectations. With a low probability of returning to
policy tools will help them keep inflation under control now. the hyperinflation of the 80s and 90s, the main risk is that
monetary policy is tightened too early before activity has
Conclusions returned to pre-pandemic levels. If the rise in inflation proves
Overall, the recent increase in inflation in Latin America is temporary, central banks would be expected to adopt a more
not yet a cause for concern. Economies have struggled to dovish tone and focus on policies supporting economic growth
contain the spread of new Covid-19 variants, which will create for the remainder of 2021.
6. Historical inflation in Latin America (CPI %, year-on-year)
210 14000 1990s’ 60
inflation-
180 12000 targeting 50
measures
150 10000 40
Rates before
120 8000 30
% % %
90 6000 Rates after 20
60 4000 10
30 2000 0
0 0 -10
1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 1996 98 00 02 04 06 08 10 12 14 16 18 20 22
Mexico Chile Colombia Peru Brazil Mexico Chile Colombia Peru Brazil
(rh axis) (rh axis)
Source: Refinitiv and EFGAM calculations. Data as at 14 July 2021.
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