Latam Charts: Back to School

• Recent speeches by central bankers have reviewed the lessons learned in dealing with inflation. Most important is the risk of easing restrictive stances in response to early signs of lower inflation, which can lead to a higher cost in terms of output and unemployment.

• Most Latam central bankers appear to have heeded this lesson, raising real (inflation-adjusted) policy rates to contain inflationary pressures, thereby anchoring longer-term inflation expectations and reducing one source of uncertainty for local financial markets.

In the Northern Hemisphere, the start of September marks the end of summer holidays and the return to school. At the recent annual Jackson Hole conference of central bankers, Fed chair, Jerome Powell, adopted a professorial tone, lecturing on the lessons learned from past inflationary episodes. His message: central banks that temporize with inflation, relaxing their restrictive stance at the first signs of abating pressures, ultimately pay a higher price in terms of inflation-output trade-offs. Other central bankers, notably from the ECB, followed Powell's lesson plan.

Central bankers' schooling of markets in the dangers of relaxing vigilance in the fight against inflation should disabuse those anticipating early rate cuts on lower inflation numbers. The Fed and other central banks are now clearly concerned that expectations of higher inflation are at risk of becoming embedded in decision-making. If that scenario were to unfold, the costs of bringing inflation down, measured in terms of output losses and higher unemployment, would increase. And that is what Powell and his colleagues want to avoid.

There are two corollaries to this thesis. The first is that nobody should expect cuts to monetary policy rates anytime soon. Central banks will not ease until price pressures have been purged from the economy and inflation expectations firmly returned to target on a durable basis. The second corollary is that recession risks have likely increased, albeit more so for Europe, which is faced with severe supply side shocks from higher energy prices. In that event, however, negative output gaps should accelerate the moderation of inflation expectations, bringing forward a shift in the stance of monetary policy.

Both of these effects have been priced into markets in recent days, with equity prices selling off sharply. And for the Latam region, global financial conditions remain challenging. Nevertheless, with the US dollar appreciating against most currencies around the globe, stoking inflationary pressures through exchange rate pass-through effects, several of the region's currencies have held their own. (Argentina's peso, in contrast, has depreciated sharply, reflecting the pervasive uncertainty there with respect to macroeconomic policy management and the risk of financial instability.)

For the most part, despite recent financial turbulence, economic recoveries in the region remain on track as growth adjusts from the post-pandemic rebound to more sustainable longer-term rates. This process could be uneven, and Scotiabank's experts in Santiago point out that the Chilean economy is likely to contract over the next several quarters. Continued growth, meanwhile, would sustain job creation, which has begun to flag, and close remaining gaps with pre-pandemic employment levels.

Slower growth should relieve some price pressures where unsustainably strong consumer demand has exacerbated supply-side shocks. Scotiabank's Latam economists anticipate inflation will decline over time, with inflation-targeting central banks in the region focused on returning inflation to target ranges over the medium term. Central banks across the region now lead their global peers in terms of raising their real, or inflation-adjusted, policy rates. At the same time, the transition to more sustainable levels of consumer demand would also help reduce large current account deficits, notably in Chile and Colombia.

Longer-term inflation anchored by credible, independent central banks reduces one source of uncertainty for financial markets and supports growth and asset valuations. That said, in the current conjuncture, considerable uncertainty remains, including that coming from the political sphere. Markets will continue to closely watch the new presidential administration in Colombia, which has thus far adopted a cautious and conciliatory approach. And there are also encouraging signs that Peru's new Finance Minister is seeking to impose some order on what has been a chaotic policy-making environment. In addition, the results of Chile's plebiscite on the draft new constitution Sunday, which recent polls suggest will be rejected, could likewise be a source of political uncertainty depending on how the government responds. As our team in Santiago point out , while the prospect of rejection has boosted local asset valuations, the durability of those gains may depend on the government laying out a clear roadmap on next steps and how to address outstanding contentious issues.

The key lesson from all this is that, while governments may be unable to control or prevent external shocks, they should do their homework to ensure that their economies are insulated from them. And while it is too early to give Latam governments a final grade on their performance in the current cycle, it would appear that most have absorbed that lesson from their own past experiences with high inflation.