Will Latin America’s Largest Economies Keep Cutting Rates? This Is What Analysts Are Saying

A decline in economic activity is taking on a more prominent role in monetary policy decisions at central banks across the region

Will Latin America’s Largest Economies Keep Cutting Rates? This Is What Analysts Are Saying
August 24, 2023 | 09:06 AM

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Bogotá — After central banks in Costa Rica, Uruguay, Chile, and Brazil recently lowered their interest rates, analysts are expecting that key markets such as Mexico, Colombia, and Peru will follow suit in the coming months as inflation starts to ease. However, a decline in economic activity is taking on a more prominent role in monetary policy decisions, as outlined in a report from the financial firm Corficolombiana.

With the scenario in Mexico marked by greater uncertainty, analysts anticipate that the major economies in the region will maintain a tight monetary policy stance in the coming months due to the need to keep curbing inflation. Nonetheless, despite the ongoing decline in the pace of price increases, experts are projecting that, with the exception of Brazil, inflation will remain above central banks’ targets until the end of the year and will only return to the target range in 2024.

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Central banks in Brazil, Mexico, Peru, and Colombia continue to be concerned about the detachment of inflation expectations, according to Corficolombiana. Additionally, monetary authority boards are worried about core inflation, which has not yet aligned with targets. The report adds that “decisions in the coming months will continue to rely heavily on inflation data and expectations.”

The disinflationary process has been uneven and less pronounced in Colombia, for example. Moreover, core inflation is showing resilience despite a restrictive monetary stance.

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What Could Keep Central Banks From Reducing Rates?

In Mexico’s case, the inclination to maintain current rates reflects a greater influence of decisions made by the Federal Reserve in the United States.

Meanwhile, in Colombia, the door is opening to potential interest rate cuts as long as inflation continues to decline. There have been no specific indications regarding the near-term future of interest rates in Peru, however.

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At the end of the month, the Central Bank of Chile implemented a 100-basis point reduction in the monetary policy rate to 10.25%.

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This month, after nearly three years, the Central Bank of Brazil executed its first interest rate cut, lowering rates by 0.50 percentage points to an annual rate of 13.25%.

According to analysts at Corficolombiana, “The scenario of rate cuts assumes that inflation in the region will continue to decrease from current levels, ensuring convergence with the respective targets of monetary authorities.” However, “upside risks of inflation are significant. On one hand, the arrival of the El Niño phenomenon would mainly impact food prices, as agricultural production is vulnerable to adverse weather conditions. On the other hand, a more extended persistence of the core component or a more hawkish stance by the Fed would support central banks in implementing more conservative rate cuts.”

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Impact on Debt Markets and Exchange Rates in LatAm

While a reduction in interest rates would result in greater access to credit for individuals and businesses, the normalization of monetary policy could also affect debt markets after a period in which Latin American assets have benefited from a considerable interest rate spread compared to the US.

The document also adds that these assets were boosted by reduced global risk aversion due to waning concerns about a recession, reduced political uncertainty in the region, and the performance of export commodity prices.

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In the second quarter, Latin America received net inflows of $8.6 billion, representing the second-highest net investment among emerging market groups, following Asia ($42 billion).

On average, 5-year local currency bonds from Brazil, Mexico, Chile, Colombia, and Peru appreciated by 123 basis points in the first half of this year.

In connection with this, the interest rate spread favored carry trade with Latin American currencies, boosting the Colombian peso, the Mexican peso, and the Brazilian real as the strongest currencies in the region so far this year.

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Now, “the process of monetary normalization will limit further appreciation in the region’s debt markets, despite the interest rate spread with advanced economies remaining wide.” In fact, central bank decisions in the region toward monetary normalization could have an impact in exchange rates and reverse the trend of appreciation observed so far this year. “Evidence of this was the behavior of the Chilean peso against the dollar after the rate cut in July. In the two weeks following, the USD/CLP exchange rate against the dollar lost 4.4%, while the average depreciation of the exchange rate of its regional peers was 1.4% in the same period and was influenced by the strengthening of the dollar globally,” the report concluded.

Read more at Bloomberg.com