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Will Inflation Hurt Latin GDP?

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Will rising inflation cut short Latin America’s economic expansion?

CHRONICLE SPECIAL
Knowledge@Wharton

Inflation has begun to accelerate at a significant pace in Latin America, much like it has in the United States and Europe. The main reasons for the inflationary spiral are today’s higher global prices for crude oil and such agricultural commodities as corn and wheat. The price of crude oil has risen 90 percent over the past year, reaching a peak of above $147 a barrel in July. Corn has doubled over the past 12 months.

Dominique Strauss-Kahn, director general of the International Monetary Fund, warned on July 7 that inflation is a big problem in some parts of Latin America. “In some emerging countries and others with low income, inflation is getting out of control. This means that monetary policy probably needs to be adjusted,” Strauss-Kahn told a group of reporters in Toyako, Japan, Japan during the summit of the G-8 industrialized nations. Strauss-Kahn did not specify exactly which countries, but she indicated that she was talking about Latin America and Africa. Strauss-Kahn warned the leaders of the G-8 nations that although “growth is an important question, inflation is probably the greatest threat for the economy today.”

UPWARD MOVEMENT

“Expectations for inflation are consistently getting higher,” notes David Alfredo Tuesta Cardenas, professor at the Pontifical Catholic University in Peru. “In those countries where central banks produce and publish surveys, you can see an upward movement of between 0.5 and 1 percentage point over the short term, and between 0.3 and 0.5 points in the projections for inflation over the next two or three years.” The cause for that, he says, “is basically the strong impact that higher prices for food and fuels are having [on prices].”

You can see that in every country in the region. In Chile, short- and medium term expectations for inflation suffered a significant upward revision, according to the latest survey on economic expectations by the country’s central bank. In June, expectations for the end of the year rose to an annual rate of 7.5 percent, compared with projections of 5.5 percent made the previous month. Moreover, forecasts for the next one and two years are also worsening to 5.5 percent and 3.8 percent respectively (up from 4.5 percent and 3.5 percent in the previous survey.)

“Day by day, inflation is becoming more of a nightmare for the Argentine economy,” said Altina Sebastián González, professor of finance at the Complutense University in Madrid. The Consumer Price Index for May reached a year-to-year rate of 9.1 percent, “a percentage that underestimates real inflation for most Argentines.” In addition to external causes noted above, adds Sebastián, “are some underlying internal causes associated mainly with the growth in domestic spending at annual rates of about 9 percent, which far exceed the potential growth rate of the GDP, which is about 3.1 percent to 3.4 percent a year, according to my estimates.”

MEASURES NOT WORKING

Sergio R. Torassa, professor of finance at the Pompeu Fabra University, explains that “the government headed by Mrs. Kirchner is carrying out an economic policy that attempts to shield the population from the effects of rising international prices. As a result, it has implemented a range of measures. These include targeted subsidies toward different sectors of the food chain such as the milk and poultry industry) mechanisms for tax deductions – which until this week incorporated variable deductions for soy, sunflower, corn and wheat and which have led to great conflict in the agricultural sector; and the prohibition and reduction of export quotas (for mutton, fuels, wheat), which provide preferences to local suppliers.” Nevertheless, Torassa believes that “these measures aren’t working, as you can see from the fact that inflation for foods and drinks is practically as high as the overall inflation level. Nevertheless, when you look at the underlying inflation rate, it winds up being higher, which suggests that the higher rate of inflation is tied to domestic factors.”

Along the same lines, Hugo A. Macías Cardona, professor at the University of Medellín in Colombia, notes that “the mechanisms used for controlling inflation are not working; we are facing an exhaustion of the scheme for dealing with ‘objective inflation,’ which was first applied to Latin American monetary policy after they solved the problem of hyperinflation.” Macias explains that with this approach to objective inflation, officials “attempted to coordinate macroeconomic policy so they could avoid having inflation rates jump up whenever the economies [of the region] started to pursue a new path toward growth.” However, he believes that monetary policy “has become an impediment to growth, and a source of instability and disagreement.”

The CPI in Brazil increased in May to a 5.6 percent annual rate, according to official government data. This confirmed the upward trend that began in June 2007. The underlying reasons, according to Sebastián, were “very strong domestic demand, accompanied by increased prices for energy in agricultural products. Retail sales in Brazil grew in March by 8.7 percent, and auto sales jumped by more by more than 38 percent, compared with the previous year.

FIVE-YEAR HIGH

In Peru, inflation continues to rise, reaching an annual rate of 5.4 percent for the eighth consecutive month, and exceeding the inflation rate established by the Andean central bank. In Colombia, the CPI reached an annual rate of 7.2 percent, the highest figure in five years. Although Panama has one of the lowest inflation rates in Central America, prices are growing at a faster pace than in nearly 25 years. Inflation in Panama accelerated in June to an annual rate of 9.6 percent. According to Torassa, “In that specific case, where they use the dollar as their currency, they have also been under inflationary pressure because of the weakness of that currency in international markets. That makes their imports, which are mostly from Europe, more expensive.”

Mexico has been the strongest performer in all of Latin America. While inflation is on the rise, it continues to be very moderate. In April, both the CPI and the underlying inflation rate grew by an annual rate of 4.5 percent, a bit below the figure registered at the end of 2007. Although Mexico is a major producer or crude oil, it cannot avoid suffering some impact from rising prices for other commodities, notes Sebastián, but it “benefits from the excellent performance of unitary salary costs, which increased at an annual rate of only 1.4 percent in February. In addition, productivity is growing.”

Beyond the peculiarities of each country, Macias notes that some factors unique to Latin America help explain the price rises. It’s not just the result of higher prices for petroleum and food. These other factors include “the exhaustion of the monetary policy model that excessively simplifies the functioning of the market and which does not account for all of its complexities.” This outbreak of inflation, he adds, “requires more creativity in monetary policy, which means going beyond controlling interest rates and the quantity of money in circulation.”

Rafael Pampillón, professor at the IE business school, emphasizes the importance of the close economic relationship with the United States. “The U.S. is suffering some significant increases in its CPI, which are the result of the expansionary monetary policy undertaken by the Federal Reserve. And the U.S. is exporting inflation to its main trading partners, such as the countries of Latin America,” he notes.

THE DANGERS FOR GROWTH

The steep rise in Latin American inflation will have consequences for the economies of the region. Obviously, notes Torassa, “higher inflation rates bring increased interest rates, which lead to a reduction in economic growth. Nevertheless, on this occasion Latin America is better prepared than in the past to deal with this situation successfully.”

Macias explains that inflation has an especially negative impact on poor people because basic commodities are subject to the largest price increases. In addition, poor people spend a higher percentage of their incomes on products that are getting more expensive. This also has a notable impact on borrowers, he says, “especially those people who own property that has stopped rising in value. Rising inflation could also spark a new mortgage crisis. Just as companies are experiencing a significant increase in their financial costs, inflation has a recessionary impact on the economy. Inflation can produce a mortgage crisis and can lead to economic stagnation in the region.”

Tuesta believes that the greatest risk is that “this could wind up leading to an inflationary spiral because of pressure to raise salaries.” Pampillon recalls that the region has enjoyed an extended period of clear sailing; some five consecutive years of strong economic growth. According to him, this phase of expansion “can come to a halt because of this very high rate of inflation and rising interest rates.”

DECISION OF CENTRAL BANKS

What position should central banks take to address the threat? During the 1980s, says Macias, there was an important change in Latin American economic policy that resulted from the very high levels of inflation [suffered] in earlier times. “There were a lot of changes and they were very complicated. However, one of the most important changes was that they decided to create independent central banks that had the main function of controlling inflation, to the detriment of the ‘real’ variables in the economy, such as levels of production and employment. The result was that the economic growth rate during the 1980s and 1990s was lower than the economic growth rate in earlier decades. Now, that model has been exhausted. The privilege of enjoying stability, along with monetary factors, generates serious structural problems that make it hard for the economy to grow faster.”

Macias says that banks need to “coordinate their decisions with the rest of economic policy. That means allowing inflation to rise to higher-than-current levels in order to avoid causing a severe recession and an even greater increase in unemployment. Institutionally, this position is very hard for the central banks because it is outside the area where they are designed to play a role.”

Although any increase in the cost of money can be harmful to economic growth in the region, Tuesta believes that central banks should not renounce their chief goal of keeping inflation under control. “[Interest] rate increases must be a priority when you look for ways to control these inflationary pressures, even at the risk of recession. The history of Latin America shows that the risk of living with rising inflation is much more harmful over the long run [than recession],” he warns.

Pampillon has a very similar view. He believes that institutions that regulate monetary policy have no other choice but to raise interest rates. “It is very hard to correct an inflationary economy. Beyond that, there is a growing consensus among economists that price stability is essential for economic growth,” he says.

Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania. 

 

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