The Mystery of a Rising Inflation in Latin America

As a consequence of the global financial crisis Latin American inflation is expected to fall as it did after the crisis of the end of the century. But the mystery is that inflation in Latin America has being rising (see the figure where data covers until October 2008). Most probably this is because of backward looking expectations embedded in wage contracts, price adjustments and rules for regulated prices and because the depreciation of the exchange rates has offset the drop in dollar-measured imported inflation.

In contrast to the recent inflation figures, what the global financial crisis means for monetary policy in Latin America is disinflation. This is because economic activity would recede. The output gap is turning negative. As output drops, core inflation is expected to drop and as commodity prices crash headline inflation is expected to decrease strongly too. The slump in activity in the region does not seem as protracted as during the crisis of the end of the century, hence, the expected disinflation looks slower.

The US-deflation scenario does mean exchange rate depreciation as debt deflation would entail further liquidation of the relatively risky Latin-American securities. But the effect of the exchange rate on inflation is short lived while that of economic activity is lasting and decisive.

An appreciation of Latin American currencies cannot be ruled out either. This would be the case if the dollar depreciates. Exchange rate appreciation would add to the disinflationary forces of the drop in output and in international inflation.

In 2008 real interest rates have decreased in most inflation targeting Latin-American countries as inflation has risen. Hence, the expected drop in inflation is explained more by the global financial crisis and less by a tight monetary policy. The graph below shows the real deposit interest rate in five Latin American countries that have inflation targeting. (These countries account for 77.7% of Latin-American GDP). During the upper phase of the cycle, 2005-2008, real interest rates were above the long term average only sporadically.

To conclude, backward looking expectations embedded in wage contracts and price adjustments are likely to be revised downwards as inflation surprises on the downside. Inflation rose strongly in 2008 in Latin America but the good news is that this means some cushion against the scenario of a possible US-deflation.


One Response to "The Mystery of a Rising Inflation in Latin America"

  1. Alex Baran   December 4, 2008 at 9:24 am

    Latin America is a hot market for vision systems. I read at what the common applications for the packing industry include. Latin America’s markets usually have high import fees or custom duties. The import fees for a machine vision system may be up to 90% of the total equipment costs.