An aggressive 125‑basis‑point policy rate rise by Chile in mid-October has provided yet another signal that Latin America’s central banks are responding firmly to inflationary pressures, with a monetary-tightening cycle that is likely to endure for much of 2022. Headline inflation has spiked in the region this year; this would not be so worrying for the monetary authorities were it not for the recent upward drift in inflation expectations, which threatens to complicate the price-setting process. Meanwhile, the Federal Reserve (the US central bank) is becoming increasingly hawkish and is now set to begin raising its policy rate at some point in the second half of 2022, placing Latin America’s central banks under even more pressure to tighten rates to prevent a damaging currency slide. These pressures for tighter monetary policy look set to be a significant headwind to the economic recovery in 2022.

In a region with a hard-won reputation for price stability, central banks are sensitive to the effects of inflation, even where the source of inflation is transitory and supply-side in nature. Inflation has been trending up throughout the year in response to persistent exchange-rate depreciation, commodity price rises, recovering domestic demand and temporary supply shortages. In most cases, inflation expectations (12‑month‑ahead, and sometimes even further out along the monetary policy horizon) have also started to creep up, to above the mid-point of the target range of most of the key inflation-targeters in the region (Peru, Mexico, Colombia, Chile and Brazil). Any drift in inflation expectations in these countries is typically a sign of rate rises to come, and this time has been no different. Real ex ante policy rates (the nominal policy rate minus 12‑month‑ahead inflation expectations) in the region are already positive in Brazil and Mexico, highlighting a definite shift in policy stance; real rates are headed in the same direction elsewhere too.

Latin America, led by Brazil, started raising rates earlier than its emerging-market (EM) peers, and although several EMs have followed suit, such as Poland and Russia, Latin America’s rate rises have, as a group, undoubtedly been the most aggressive this year. The region’s central banks will be looking ahead to the tightening of monetary policy in the US next year; getting a head start on monetary policy tightening will not guarantee that Latin America manages to avoid another “taper tantrum”, but it does at least help to prepare the ground for a reasonably orderly exit from an extremely accommodative US monetary policy stance. This is important for Latin America, because pass-through from currency depreciation to consumer price inflation in 2022 could be higher than usual, bearing in mind that producers and retailers have already been forced to absorb huge rises in producer price inflation this year.

However, an aggressive tightening cycle carries risks. Higher interest rates will increase debt-servicing costs for the region’s increasingly indebted public sector and place even more pressure on governments to tighten fiscal policy. Apart from raising creditworthiness concerns and potentially placing some significant liquidity pressure on certain highly indebted sovereigns, interest-rate rises will prompt sharper fiscal consolidation, dampening what has proven to be a fairly robust economic recovery so far this year. The latest monthly data (to July) show that economic activity has in many cases returned to pre-pandemic levels already, bolstered by high hard and soft commodity prices, and by adaptation to the reality of Covid‑19. Business appears to have mostly shrugged off new pandemic-related restrictions amid what have until now been still quite accommodative conditions at home, and booming demand abroad.  

For Latin America, the big challenge for 2022 is to produce a self-sustaining economic recovery able to withstand what are likely to be much tougher conditions next year. Our forecasts currently assume that growth in the region will slow to 2.6%. Although this is the slowest pace of any region in the world, it does still assume some modest to moderate sequential growth over the course of the year; there is a risk, in our view, of a more significant setback to the recovery in 2022 than we have currently pencilled in if monetary policy normalisation next year does not go smoothly.