Central Bank independence and COVID-19 in Latin America

Financial crisis
Financial institutions
Financial Economics

Like in previous crises, central banks are at the forefront of the policy response to the global economic upheaval generated by the COVID pandemic. The U.S. Federal Reserve has slashed interest rates and the Bank of England has cut its policy rate to an all-time low. These central banks have also taken sweeping measures to provide banks with liquidity in an effort to alleviate stress in financial markets and support economic activity. Moreover, the U.S. Federal Reserve is partially monetizing the $2 trillion CARES Act, while the Bank of England has announced that it would provide direct financing to the government if necessary. Should central banks in Latin America follow suit and monetize fiscal deficits as the public health crisis worsens and after the pandemic is over?

While the crisis is in full swing, central banks have been the first line of defense in Latin America. Based on medium-term expectations of low inflation and sharp increases in output gaps, central banks in Brazil, Chile, Colombia, Mexico, and Peru cut their policy rates in March, some countries more aggressively than others. Central banks also extended liquidity through an array of instruments, in both domestic currency and in dollars, in the spot market, and through swap operations. In addition, several countries have also announced expansionary fiscal policies to mitigate the adverse impact of the crisis on economic activity, on employment and, in general, on social welfare. Countries will also benefit from mounting resources provided by multilateral organizations, in addition to the swap operations provided by the U.S. Federal Reserve to Brazil and Mexico.

While fiscal deficit monetization has not yet taken place—except in Argentina, where one third of the monetary base was transferred to the government in March—it may happen down the road. Countries may exhaust their fiscal space and external financing may not suffice if the public health crisis and economic disruptions persist. However, unlike the U.S. and the U.K., who issue a reserve currency, monetizing the deficit in Latin America will undermine central bank independence, a fundamental pillar of monetary policy in the last 25-30 years, which has helped defeat chronic inflation and even hyperinflation (Figure 1). Yet, the gravity of the crisis could induce countries to monetize the fiscal deficit either directly or, if legally banned, indirectly through state-owned banks, and markets may not react negatively if this action is taken for specific COVID-19 related purposes.

But should central banks keep financing fiscal expenditure during the crisis’ recovery phase? Countries in Latin America will likely face economic depression, vast unemployment, and probably a heavy debt burden once the health crisis is abated. They also might not be able to fully rely on financial support from international multilateral organizations, as these institutions will probably face excess demand from their member countries. Governments may thus turn to central banks for continuous financing in order to fuel the economic recovery. However, this is a risky strategy. Monetizing the fiscal deficit is likely to become addictive, as politicians may deem that the benefits of expanding public expenditure in a devastated economy outweigh the costs of relaxing central bank independence.

Latin America could learn from its own history about the disastrous effects of perpetuating central bank financing of the government. A distant but illustrative lesson comes from central banks’ policy response during the Great Depression, when monetary policy succeeded in pulling countries away from the brink of economic collapse. In the early-1930s, institutional reforms were introduced to allow central banks to finance government expenditure at preferential interest rates. As a result, central bank assets surged, with credit to the government becoming the largest item, as displayed in Figures 2 and 3 for Chile and Peru, respectively.

Despite economic recovery, Latin America did not reverse the monetary legislation introduced to address the initial crisis. Thus, governments continued to rely on central bank financing in order to avoid paying the political price of raising taxes or cutting expenditure. As a result, inflation surpassed 25 percent in Chile by 1942 and 15 percent in Peru by 1944. With governments having open access to the central banks’ coffers, Latin America underwent a prolonged period of inflation that lasted until 1990, when the average rate reached close to 500 percent (IMF’s World Economic Outlook database). It took widespread erosion of real incomes and social discontent to move Latin American governments toward granting their central banks independence in order to focus monetary policy on fighting inflation.

This historic episode illustrates how a well-intentioned monetary policy reform—which allowed central banks to prevent an economic meltdown and help economic recovery in the 1930s—sowed the seeds for the high inflation that battered Latin America in the subsequent 50 years. This time, central banks should alternatively keep a policy of low interest rates and implement credit easing to boost economic recovery. Yet if governments choose to keep monetizing the fiscal deficit, they should ensure that the central bank financing is temporary and limited, and design a clear exit strategy from the onset as a way to reduce the damage on monetary policy’s credibility for years to come.

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