In our recent article on the divergence of monetary policy, we looked at the varied state of rate hikes among G10 countries. Some of their central banks have raised interest rates up to the level of core inflation, while others still have policy rates well below the pace of year-on-year consumer price increases. However, G10 central banks were not the leaders of the current tightening cycle. Rather, it was the Latin American central banks in Brazil, Chile, Colombia and Mexico who were at the forefront of the current tightening cycle (Figure 1) -- well ahead of the even the Bank of England (BoE) and the Federal Reserve (Fed), the first two of the North to lift rates.
Figure 1: LATAM central banks raised rates earlier and faster than peers like the Fed
Latin American central banks may have been faster to raise rates than their peers in places like the U.S., Europe and Australia because their memory of high inflation was more recent and, being more attuned to the risks, recognized it more quickly. A quarter century of low inflation, which generally hovered around 2% in annual rises in core inflation or lower, in Australia, Canada, Europe and the U.S. may have lulled their central banks into a false of security against high rates of inflation. This was not the case in Latin America, where central banks fought more recent battles against inflation. In Mexico, for instance, inflation sometimes approached 6% from 2008 to 2021 (Figure 2). The Bank of Mexico has raised rates by over 700 basis points (bps) so far, dwarfing the Fed’s 500 bps cumulative rate hike which, in turn, is larger than the rate hikes in Europe, Canada or Australia.
Read our article on the divergence in monetary policy among major central banks here.
Figure 2: Mexico’s central bank has raised rates well above core inflation
In Colombia, inflation was over 6% as recently as 2016, and around 8% in 2008. As such, when inflation began surging in 2021, Banco Central de la Republica de Colombia raised rates aggressively, eventually bringing its policy rate to over 13% (Figure 3). It’s been a similar story in Brazil, where inflation was often in a range of 4% to 9% pre-pandemic, and surged to double digits by 2022. Banco Central do Brasil raised rates to nearly 14%, well above the rate of inflation (Figure 4). Meanwhile, Chile had experienced mostly low inflation, usually around 3%, between 2009 and 2021, but had seen inflation spike to 9% in 2008 and nearly 6% in 2014. During the pandemic, Chilean inflation soared as high as 14%, prompting Banco Central de Chile to hike rates to 11% (Figure 5).
Figure 3: Colombia’s central bank has also sent rates far above core inflation
Figure 4: Brazilian core inflation has begun to turn down after aggressive central bank tightening
Figure 5: Aggressive tightening in Chile is showing signs of success in fighting inflation
Early and aggressive rate hikes in the biggest Latin American economies may have played a role in the containing both inflation expectations as well as helping to reduce rates of core inflation. Moreover, the rate hikes have sharply inverted yield curves, especially in Chile, Colombia and Mexico, which may be a harbinger of a coming economic downturn (Figure 6). In all four countries, yield curve shapes correlate positively with subsequent economic growth. Positively sloped yield curves (long-term rates above short-term rates) tend to be followed by periods of economic expansion, and negatively sloped yield curves (short-term rates above long-term rates) tend to be followed by periods of economic slowdown or recession (Figure 7 and Appendix Charts 1-4). Given the steep negative slope in yield curves across the Latin American countries, it is possible that they not only led the way to tighter policy but they might also lead the way to a global economic downturn resulting from the dramatic tightening of monetary policy.
Figure 6: Sharp yield curve inversions might herald a coming downturn
Figure 7: LATAM yield curves tend to correlate positively with subsequent economic growth
It is also worth pointing out that Latin America’s currencies have diverged sharply. The Brazilian real as well as the Chilean and Colombian pesos, which are traditionally closely connected to commodity prices, weakened during the pandemic and post-pandemic eras; though they have found their footing against the U.S. dollar (USD) in recent months.
By contrast, the Mexican peso (MXN) has sharply strengthened versus USD and its Latin American peers as Mexico has benefitted from tremendous inflows of capital into its manufacturing sector, which many enterprises see as an alternative to producing goods in China (Figure 8). Additionally, manufactured goods account for 72% of Mexico’s exports, a far higher share than in Brazil, Colombia or Chile. While a stronger MXN will help to contain Mexico’s inflation, it can also make the country a more expensive place to produce goods and for tourists to visit, potentially slowing Mexico’s economic progress.
Figure 8: MXN has been the outperformer among LATAM currencies
Appendix
Chart 1: Chile may already be in a recession and it may get much deeper
Chart 2: Brazil’s yield curve is suggesting a sharp economic downturn may be on the way
Chart 3: Colombia’s yield curve suggests a recession may be on the way
Chart 4: Mexico’s sharply inverted yield curve suggests that the boom may be ending
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
