More Inflation or More Revaluation

Economic Policy
Macroeconomics - Economic growth - Monetary Policy

In the wake of the international price shock, Latin American economies are between a rock and a hard place.

In January of this year, international food prices surpassed the mid-2008 peak with similar consequences: popular revolts in undemocratic countries, and many speeches but few concrete actions in developed countries. In Latin America it was the usual dilemma: more inflation or more revaluation.

As net food exporters, Argentina, Brazil, Guatemala, Paraguay and Uruguay are benefiting from the high international prices but all other countries, including Mexico and the small economies of Central America and the Caribbean, are all losers. They are net importers of the basket of major food commodities in world trade; including rice, sugar, corn, soybeans and wheat.

Both food exporting and importing countries with flexible exchange rates reacted to the 2008 price shock by appreciating their currencies, making imports cheaper in the domestic currency and cushioning the inflationary effect of higher external prices. At the time, capital was also flooding in, which may have also contributed to the currency appreciations.

This time around, countries in the region may well react in the same way. If they do, the countries with flexible exchange rates may be saved again from inflation. According to an IDB policy brief, the inflationary impact would be negligible in Brazil, Colombia, Mexico and Uruguay, and reach only about three percentage points in 2011 in Peru.

The situation is more critical in most Central American and Caribbean countries, where there is less exchange rate flexibility and countries tend to be net food importers. In Bahamas, El Salvador, Honduras, Panama and the Dominican Republic, inflation could be between four and seven percentage points higher in 2011 than otherwise due to the commodity price boom. Bolivia, which also shares these features, might see a five point increase in the inflation rate due to high commodity prices. The results suggest that even Guatemala, a net food exporter with a flexible exchange rate, may suffer a seven point increase in the inflation rate due to higher commodity prices. In all cases these estimates are to be compared to what would have happened in the absence of the price shock, assuming the same market and policy responses as observed in the past. 

The crucial question is whether this time central banks and governments are going to react in the same way, allowing already overvalued currencies to appreciate more, and further weakening the competitiveness of the sectors that are exporting or competing with imports. This would aggravate informality and unemployment, and hurt farmers and agricultural workers who are not in the sectors enjoying the price boom. However, it would be a relief for the poorest sectors in urban areas who have to spend most of their income on food.

Unfortunately, the other option is no more attractive, since preventing more currency appreciation in exchange for higher inflation would have the opposite distributional effects and weaken the credibility of central banks, and ultimately result in higher interest rates. In countries without exchange flexibility this risk is cause for concern. Their only way out is a combination of fiscal and monetary policies that would cool their economies down but create its own problems of unemployment, poverty and informality.

There is little chance of escaping these dilemmas, especially in countries where internationally tradable food has a heavy weight in the consumption basket. The biggest fear is not recognizing the problem quickly and attempting to achieve everything at the same time, which would be the formula for widespread frustration and loss of confidence in economic policymakers. The sensible thing is to inform the public and encourage debate on the implications of the two situations. The authorities will have to make decisions soon and should do so in full view of the public.  

Disclaimer: The authors are associated with the IDB Research Department but their views do not commit this institution or its governing bodies.

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