Since mid 2007 inflation in Latin America surged substantially, ending a 5 year long period of inflation reduction. Initially food and fuel prices accounted for the bulk of the increase in headline inflation, but progressively core inflation rose as well, indicating that the old price propagation mechanisms were still alive in spite of successful stabilization efforts in many countries of the region. Targets set by Central Banks have been surpassed in all countries with inflation targeting based monetary policies. The record is not better for the rest.
With a long inflationary experience and its consequences on growth, poverty and income distribution, during the 90s and the present decade many countries of the region adopted reforms and policy measures aimed at bringing inflation under control, and to a good extent they succeeded at it. Even more, for many the external conditions were favorable, and so the region managed to grow for six consecutive years at an average rate above 3% per capita, (something unheard of for about forty years), with current account surpluses, falling public external debt (as % of GDP) and strengthened fiscal solvency.
In the past, inflation in Latin America was very often caused by a mixture of external shocks intensified by domestic disequilibria which required aggregate demand control to reign it in. In turn, the current increase in inflation has its origins mainly, although not exclusively, in commodities world price increases and exogenous supply shocks, augmented recently by the Fed’s response to the subprime crisis, which materialized in a sharp depreciation of the US dollar. However, not every country in the region is affected equally by this commodity boom. Policy also has differed and so perspectives, in the event of price reversals and need to control inflation and its consequences, are not equal either.
As the following graph illustrates South America, especially Chile, Bolivia, Peru, Colombia and Venezuela, benefited the most, whereas Central America and some Caribbean countries exhibit a terms of trade deterioration.
Source: Eclac, based on official data.
The mirror image of this unfavorable evolution for some of the poorer countries in the region is their heavy dependence on foods imports and high malnutrition levels. The recent increase in food prices (even if it is considered a recovery from very low levels as Ocampo and Parra article published in this site argues) will surely increase their poverty levels.
Source: Eclac, based on official data.
In this context of increased global inflation and the pessimistic view on the world economy, the governments of the region face a threefold challenge: i) Decide the extent to which the external inflationary shocks will be accommodated and domestic demand will be controlled in order to reduce inflationary propagation, ii) Adopt fiscal and monetary policies which minimize the economic cost of inflation containment, iii) Adopt policies which mitigate the social effects of the external shock and of domestic anti-inflation policy.
The first challenge poses a difficult dilemma. Since a good share of inflation is “imported”, domestic policies will not be able to affect it, and will cause some domestic activity loss. Also, one must keep in mind that SMEs depend mostly on the domestic markets and generate a very significant share of total employment, hence the social impact should be evaluated. On the other hand, authorities cannot simply renounce to inflation control, since expectations will rise and the old dissemination and inflation-perpetuation mechanisms will again be at work, with all the negative consequences on poverty, income distribution and growth.
The second challenge carries its own complications. Although so far we’ve mentioned external and supply shocks as the main culprits for the recent rise in inflation, in some cases domestic disequilibria created further pressure. It is clear then, that under the present circumstances both monetary and fiscal policies have to work in a coordinated way to control inflation. That is no easy task, since public programs are normally planned for many years and current needs (social security, health, education, etc) have to be attended to, i.e. it is difficult to reduce expenditure.
So far central banks have reacted by raising monetary policy interest rates, albeit cautiously given the partially imported origin of the shock. Although Brazil exhibits a significantly positive real interest rate, they remain moderately positive in the other countries. The exception to this is Chile, where the monetary policy interest rate has lagged behind inflation since mid 2007, thus exhibiting a negative rate in real terms.
On the other hand, in general the fiscal stance has been expansionary during the last two years, with expenditures growing faster than revenues. Even more, although the current fiscal position is in surplus, the structural position (i.e. when expenditures and revenues are projected according to the trend values of their determinants) is not strong or even negative in some countries. As many commodity prices have tended to loose some of their gains in view of an expected slowing down of the global economy, it becomes even clearer that the observed rhythm of expenditure increases cannot continue without endangering fiscal sustainability.
The answer to the third challenge is even more complex and generalization more difficult. The capacity of governments to mitigate the social effects of inflation and of policies trying to control it, depend on their current position (surplus or deficit) and the fiscal space they have been able to gain based on the increase in public revenues created by the commodities boom. Where public debt was reduced and assets were accumulated, space for compensatory social programs that will not affect fiscal sustainability is more likely. This is also true if the government is running a surplus or a moderate deficit. Here, the case becomes one of selecting the best microeconomic tool, according to each country’s institutional and political reality. But such is not the case in countries whose budget exhibits a large deficit and fiscal sustainability was not enhanced during this period, or even worse, if they belong to the group of net losers of the commodity price boom. And among the latter some of the poorer countries of the region can be found.
In these cases the challenge is more complex. Social programs to compensate the effects of inflation and particularly commodity price increases may be at the expense of other valuable expenditures (education health, public investment in infrastructure, etc). The overall gain will be small, unless huge inefficiencies are eliminated in the process.
Another alternative is external borrowing. Multilaterals have not been very much in demand recently, so there is some space there. Official Development Assistance can also play an important role in some countries, especially among those where poverty incidence is high. The international capital market resources, on the other hand, may be difficult to tap for the poorer countries of the region, especially if the current uncertainty continues.
In any case, getting indebted to finance social programs is bad policy in the log run, since it means using long term financial funds to cover for short term current (i.e non capital) expenditures. This brings us to our last point.
Fiscal sustainability is a notion that exceeds a mathematical or actuarial formula which balances expenditures and revenues over time. Budgets which are apparently balanced in the short term may soon become unbalanced when the need arises to implement social programs to confront the effects of inflation and the effects of stabilization policies. Even more, if current social needs are not being satisfied, there will be legitimate claims for increased social expenditure. And in many countries of the region the fiscal burden is low, as the following graph illustrates.
Source: Eclac, based on official data
In such circumstances, the poor will be hit both by the consequences of price increases and that of anti-inflationary policies, since the compensatory social programs will be scarce. Growth will also suffer, since lower public revenues translate into less economic infrastructure.
In the medium and long term, as income per capita increases, new demands for social goods normally arise. And if social needs are not being satisfied or contributions (taxes) are not perceived as equitable from a distributive point of view, there will be a need to redesign the balance between taxes and expenditure. In short, for an important number of countries in Latin America a new fiscal covenant is needed. One broad enough to take into account the increasing needs of defense, social security, poverty reduction, equity and growth, to name just some of the most important. Such a covenant is the principal means of attaining fiscal sustainability in the medium and long run; the main contribution of fiscal policy to stability and growth.