The challenge of monetary policy independence

London

THE United States Federal Reserve has done it again. In 2018, the prospect of higher US interest rates sent emerging markets into a tailspin. But so far this year, indications of a more relaxed Fed stance have boosted emerging-market currencies and stock markets, despite concerns about a possible US-China trade war, economic slowdown in most major economies and rampant populism.

Around Latin America, currencies and central banks are enjoying a much-needed breather. Markets had been anticipating tighter monetary policy in a number of countries, including Chile, Peru and Mexico. Now, the talk is of a wait-and-see approach before withdrawing monetary stimulus.

Even in Argentina, still battling the twin evils of high inflation and low investor confidence, the more benign external scenario allowed for a sharp, if short-lived, reduction in peso interest rates.

By shadowing the Fed so closely, Latin America's central banks are foregoing the policy flexibility - or so-called monetary independence - that their countries' floating exchange-rate regimes are intended to allow. What's more, policymakers risk relying too heavily on possible US interest-rate cuts to boost the region's economies, and not enough on tougher structural reforms and export-promotion measures.

In theory, a country with a floating currency can use local interest rates to smooth domestic inflation and output, while letting the exchange rate rise or fall as needed to achieve external balance. This is why most emerging markets have moved to floating exchange rates, and why the fixed-but-adjustable pegs once so common in Latin America are now mostly a thing of the past.

The change is broadly considered to have been a success. But practice is turning out to be quite different from what theory would predict.

When the US raised rates last year, Latin America was expected to follow. Now the Fed seems to be pausing, and so are the region's central banks. What is going on? What happened to monetary independence? Weren't local conditions supposed to determine local interest rates?

Not really. Although currency movements that absorb shocks are a good thing, central bankers seem to believe that too much of a good thing can become bad. To borrow the memorable title of a paper by Guillermo Calvo and Carmen Reinhart nearly two decades ago, they suffer from "fear of floating".

So when US rates rise, putting downward pressure on local currencies, emerging-market central banks tend to follow the Fed's lead. This is partly to limit inflationary pressures, because local-currency depreciation makes imported goods more expensive. Emerging-market central bankers also want to protect the balance sheets of local banks and companies, which tend to borrow in dollars and will face greater difficulty repaying if the local currency falls.

Now that the Fed has signalled a loosening of its stance, Latin American policymakers will probably follow the US lead again. For starters, most countries in the region are more worried about slow growth than inflation these days, and do not want their currencies to appreciate sharply. Possible Fed easing therefore gives policymakers the chance to inject some additional monetary vitamins into Latin American economies with little or no risk of higher inflation.

Argentina's recent experience highlights another reason to cut interest rates as soon as the Fed does. Starting in the second quarter of 2018, local rates had increased sharply to contain rising inflation and prop up the plummeting peso. But the record rates (as high as 60 per cent) were causing central-bank debt to snowball, a phenomenon economists call "unpleasant monetarist arithmetic". So, as soon as the Fed began sounding dovish, Argentina's central bank cut rates, hoping to prevent the debt snowball from getting even bigger.

The view that most countries' monetary policies are really made in Washington, DC, has been around for a while. Hélène Rey of the London Business School has argued that local financial and credit conditions reflect what the Fed does, almost regardless of the exchange-rate regime. This idea of a "global financial cycle" is plausible, but remains controversial.

The good news is that most Latin American economies are better prepared nowadays to deal with US interest-rate changes. In the past, the region's central banks had little choice but to follow Fed rate rises, because they needed to attract enough foreign funds to finance large current-account deficits. But nowadays, Latin America's main economies run much smaller external deficits - usually 1-2 per cent of GDP - and are therefore far less dependent on foreign finance.

The bad news is that these smaller Latin American deficits reflect relatively low investment rather than high levels of saving. Growth around the region has been lacklustre since the commodity boom ended five years ago and seems likely to remain so for the foreseeable future.

Complacently relying on looser US monetary policy to manufacture the region's next growth spurt will not help. The Fed's magic punch may be tasty, but it is no substitute for the deeper, long-term economic reforms that Latin America urgently needs. PROJECT SYNDICATE