Decisions taken by the Federal Reserve do not necessarily point to copycat moves in South America as decoupling trend intensifies. By Ben Edwards.
With the US Federal Reserve finally cutting its interest rate in September for the first time in four years, the path to lower rates in Latin America might seem a done deal for central bankers across the region, particularly as they seek to boost lacklustre economic growth.
The reality, however, is more complicated. On the same day the Fed reduced its benchmark rate by half a percentage point to 4.75%–5%, Brazil’s central bank raised its benchmark Selic rate by 25bp to 10.75%, while also signalling there would be more hikes to come.
That move cemented the recent decoupling trend across the region as interest rate decisions are gradually untethered from what is happening at the Fed. Take Chile and Peru. Both countries have been steadily cutting rates since last year, with Chile more than halving its benchmark rate from a high of 11.25% in June last year to 5.5% in September, and Peru easing from a high of 7.75% in August 2023 to 5.25% in September. Even Mexico, whose economy is the most closely hitched to the US, was able to cut rates before the Fed.
“LatAm has really surprised in this monetary policy cycle,” said Ernesto Revilla, chief Latin America economist at Citigroup. “They started hiking earlier than other regions and earlier than advanced economy central banks, and they started cutting before other central banks, particularly the Fed. The situation now is for the first time in a long while, we are facing divergence in monetary policy in the region; Brazil is now hiking while other central banks will continue cutting.”
This is partly because Latin American central banks are able to manage their monetary policies more independently now than they have been in the past.
“That doesn’t mean they’re completely protected from what happens across the globe, but Latin American currencies outside of the last few months have actually been really well behaved,” said Aaron Gifford, an emerging markets sovereign analyst at T Rowe Price. “Beyond that, even the pass-through from FX moves to inflation has also reduced pretty substantially in the last few years. That probably speaks to the credibility of policy-making and monetary policy functioning well.”
This greater policy autonomy is also partly because Latin America has historically been prone to financial crises, and those experiences have sharpened government awareness about the need for central bank independence.
“They understand that they need to let central banks do what they need to do in order to preserve confidence, avoid sell-offs in currency markets and to contain price pressures,” said Todd Martinez, Americas sovereign co-head at Fitch Ratings.
That is the case even where central banks may not be fully autonomous but their presidents begrudgingly let them do what they need to do, he said.
“Maybe they complain about it, as we’ve seen happen in Brazil and Colombia recently, but they don’t seem inclined to really aggressively influence central banks, perhaps because they know that doing so might be counterproductive as it could put further pressure on currencies and the outer end of the yield curve.”
Despite the region’s central banks demonstrating more autonomy, currency concerns may reduce the scale of further rate cuts even as the Fed starts easing. Take Mexico. While Banxico cut its benchmark rate in August by 25bp to 10.75%, it was only the second time it had done so in three years – and it wasn’t a unanimous call, given the peso’s recent weakness. It is not just Mexico that has been experiencing FX strains, either: Latin America’s six largest economies have all seen their currencies weaken against the dollar this year. That means the region’s central banks are unlikely to be in a hurry to chase the Fed lower.
“While they’re in a position to be cutting rates before advanced markets because they were so proactive in raising them in the first place, even at these high levels rate cuts can put pressure on their currencies, which then feeds through to inflation and confidence,” said Martinez. “So, even with rates well above the Fed rate, they are constrained somewhat in the aggressiveness with which they can ease because of what might happen in currency markets.”
There is also a debate about how much room Latin America’s central banks have left to lower rates, given the floor may not be as low as it was pre-pandemic when Brazil was at 4.5% and Mexico at 7.25%.
“Central banks are still trying to calibrate what is the new terminal rate post-pandemic, because in most of our forecasts, most of the central banks in the region will continue cutting – either a little like Chile and Peru or a lot like Colombia and Mexico – but in all cases, the terminal rate of the cutting cycle is above what we had pre-pandemic, and I think that central banks and the market are still trying to see if this is the new normal or not,” said Revilla.
Commodity question
The region’s central bankers also have other challenges to navigate that could impact rate-setting decisions, not least what is going on in commodity markets. Copper prices, for instance, were about 20% lower in August from their May highs – a blow for Chile, the world’s largest copper exporter.
“On one hand, it will ease inflationary pressures if you have lower commodity prices, but since South America is a significant commodity exporter, it can also bring more challenges regarding FX, terms of trade and current account imbalances,” said Cassiana Fernandez, head of Latin America economic research at JP Morgan.
Inflation concerns have not entirely receded either. While price rises have slowed significantly since the pandemic-era peak, the pace of disinflation has been mixed. Colombia, with annual inflation still running at above 6% (albeit down from just under 11% a year ago), is someway off its target band of 2%–4%. And while Chile is back near target, prices have been accelerating again, rising from 3.7% in March to 4.7% in August.
Furthermore, monetary policy is not always as effective in the region, limiting a central bank’s reach.
“The transmission channels of monetary policy in LatAm has also been a little bit more clogged, especially if you look at credit penetration in countries like Mexico – that is something that does constrain monetary policy transmission,” said Fernandez.
Market watchers say Mexico and Brazil are the two central banks in the region that have the toughest job in the coming months. In Mexico, for example, constitutional reforms have been prompting investors to re-evaluate their exposure to the country, which could impact the extent to which the central bank can reduce rates.
“That is creating a lot of nervousness and volatility in the market and Banxico will have to think very clearly on how to manage that, because politically they don’t want to confront the incoming administration,” said Revilla.
“Our base scenario is 75bp of cuts in 2024, and 200bp more in 2025. But the level of uncertainty around Mexican rates has increased quite a lot since August, when the central bank was more dovish than expected, and therefore Banxico is harder to read right now by the market.”
The peso weakness is not helping the central bank either, with the currency losing about a fifth of its value against the dollar over the past six months.
“About half of the Mexican peso’s move since April was down to the Japanese yen/carry unwind, but there are a couple of other factors involved,” said Gifford. “First, the peso was probably overvalued earlier in the year, so the initial repricing was healthy. But after the election in June and Morena essentially winning a supermajority in congress, markets got spooked. Valuations are probably fair now.”
However, that backdrop should not take investors by surprise, said Deutsche Bank’s head of emerging market strategy, Drausio Giacomelli. For starters, the outgoing president, Andres Manuel Lopez Obrador, and his incoming successor, Claudia Sheinbaum, are only following through on what they said they were going to do by enshrining social spending into the constitution and reforming the judiciary.
“It’s not an about-face change in policymaking but it does deteriorate the quality of the fiscal accounts and increase the rigidity of spending, so they are taking steps towards the malaise we’ve seen in Brazil,” said Giacomelli.
“However, it’s a country with a spending level that’s much lower – the lowest in LatAm – so I would say the starting point for Mexico is better. And institutionally they’re in a better starting point too, even if there has been a deterioration on checks and balances.”
Giacomelli said while that does limit what the central bank can do, he believes that once the dust settles, Mexico will want to be in a position where real rates are high.
Brazil’s central bank also faces a more difficult path in the months ahead, not helped by an ongoing spat between leftist president Luiz Inacio ‘Lula’ da Silva and central bank governor Roberto Campos Neto (nominated for the post by Lula’s predecessor, Jair Bolsonaro). Lula has repeatedly criticised the central bank for maintaining excessively high rates; he also accused the central bank governor of trying to harm the country by not cutting rates fast enough.
The central bank had reduced rates from 13.75% in July last year to 10.5% in August, but that public squabble has impacted confidence. With Brazil’s economy growing strongly and inflation expectations heading higher, the central bank was forced to raise rates in September – a situation that was entirely avoidable, according to Giacomelli.
“They could have stayed on hold for longer,” he said. “Patience would have dealt with it. But when you combine the scepticism that the market now has, the central bank is cornered. The government has a huge deficit, it needs funders, and because most of the funding is coming from domestic sources, you can’t scare them – you need to play ball.”
While the central bank has indicated more hikes are to come, it may not have to be as drastic with its rate rises as some are predicting.
“In Brazil, the market is pricing 250bp of hikes in the next 12 months – we don’t think that; our baseline is that the central bank has more room to play with,” said Fernandez. “With the Fed easing, it’s a more benign environment for risk assets and EM currencies in general, so that should help the central bank as well.”
Divergence opportunities
This divergent interest rate environment is creating opportunities for investors in the region.
“Thematically, we’ve tried to be long the laggards in terms of the easing cycle, so those that still have a lot of cuts to come like Mexico and Colombia, and then maybe lightening up on the early movers such as Brazil and Chile,” said Gifford. “Peru has been a long-term favourite of ours, but it has got to the point where we think it’s fairly valued and they’re also much further along in their easing cycle as well.”
However, even though there remains a high interest rate differential between the US and Latin America, big capital inflows have so far been elusive and that is unlikely to change, said Martinez. Part of that is due to the wider economic backdrop, which – Brazil aside – has been lethargic. For example, the IMF in July revised its growth forecast for the region down to 1.9% this year from 2% in April.
“Broadly speaking for Latin America, growth is a problem, which feeds through to social stability, politics and the business climate in a negative feedback loop,” said Martinez. “There are not very good reasons to think that things are going to get much better. Most of the exceptions are the smaller frontier economies – the likes of Dominican Republic, Paraguay and Costa Rica – but, for the big economies, we don’t see a particularly rosy outlook.”
Take the Andean economies. While there has been a slight recovery, there has been nothing to suggest a return to historic growth levels, said Martinez.
“In Colombia, we’re seeing extremely weak investment relative to where it was several years ago. There is a lot of political uncertainty in Peru and then a lot of noise around reforms in Chile. So, a lot of those things aren’t particularly auspicious for their growth outlook.”
Mexico, too, has been experiencing anaemic growth. While one potential reason is that very tight monetary policy has constrained credit growth, the fact Mexico’s credit market is among the shallowest in the emerging markets means high rates shouldn’t be as much of a drag as they might be elsewhere, according to Martinez.
“There’s also been a big fiscal stimulus this year, but that doesn’t seem to have offered much of a boost,” he said, suggesting the drag may be coming from what until recently had been a strong currency, as well as slower remittances, the US manufacturing downturn and election-year uncertainties.
Yet while Latin American growth has been sluggish, the outlook is potentially more promising next year. The IMF was predicting growth of 2.7% in 2025 in its July World Economic Outlook update, up from its 2.5% estimate back in April.
“Our view is that 2024 is a year of slowdown for the region, but I think everybody understands that this is a normalisation of growth post-pandemic and the effect of high interest rates in the region,” said Revilla. “We are optimistic on a cyclical recovery in 2025 because with lower rates in the US and lower rates in the region, this should help economic activity rebound somewhat.”
The region also has several underlying trends that could support this more optimistic view. For instance, supply chain nearshoring could benefit Mexico, even if that narrative has been challenged by the recent structural reforms, says Fernandez.
“There is also increasing demand for rare earth minerals like lithium, which is benefiting the likes of Bolivia and Chile,” she said. “So there is a positive underlying story that does support the region in the medium term. The big question is if current governments will do what is necessary to attract the investment into the region.”
What is clear is that the region has proven more resilient than it has previously, and that is good news for Latin America’s central bank chiefs.
“As much as we want to say LatAm is a puppet of commodities, the resiliency to political cycles, external issues and geopolitical shocks has been quite remarkable,” said Giacomelli. “It’s encouraging for the region.”
To see the digital version of this report, please click here
To purchase printed copies or a PDF of this report, please email shahid.hamid@lseg.com in Asia Pacific & Middle East and leonie.welss@lseg.com for Europe & Americas.
