Stronger dollar still set to fuel inflation in Latin America, despite weak growth

September 10, 2015

A customer selects bananas as others buy goods at a fruit and vegetable store in CaracasFor months, Latin America’s inflation has been surprisingly steady given the steep drop of their currencies. Weak growth helped curb prices – but that may be about to change.

Latin American currencies have fallen off a cliff in recent months as China reduces demand for raw materials and financial markets anticipate an interest rate increase by the Federal Reserve. The Brazilian real, one of the world’s most battered emerging currencies, has lost more than 30 percent this year, while Mexico’s and Colombia’s exchange rates hit record lows.

Surprisingly enough, consumer prices have remained steady across the region for most of that time.

In Chile, Peru and Mexico, inflation has remained quietly around 3-4 percent, and in Colombia it has stopped increasing significantly in the first quarter of the year – when the U.S. dollar rally was still beginning to gain speed.

In Brazil, where inflation has been higher at near 10 percent, no one can blame that on the stronger dollar: most of the price increases have been related to a sharp increase in government-regulated prices by President Dilma Rousseff, who has scrambled to plug a growing budget deficit.

The missing link between currency markets and consumer prices has to do with Latin America’s economic slowdown. Particularly in Brazil, where the economy is crashing into its worst recession in 25 years, economists say there is little room for companies to jack up prices while hundreds of thousands of workers are losing their jobs.

But that may have already started to change, recent inflation data suggest. Consumer prices in Chile rose 0.7 percent in August from July, topping expectations for an increase of 0.5 percent as prices of tradable goods increased 1.1 percent (up from 0.5 percent in the previous month).

In Brazil, recent wholesale price measures have started to show growing pressures on agricultural prices, many of which commodities priced in dollar such as soybeans and corn. Although August’s consumer price index came in line with market expectations, at the lowest monthly rate in 13 months, the central bank on Thursday noted some “deterioration” in the balance of risks for inflation and signaled it could resume raising interest rates from an already incredible 14.25 percent, a nine-year-high.

Things will only get worse after Standard & Poor’s on Wednesday stripped Brazil of its investment-grade rating after just seven years. Investors fear other agencies could follow suit, sending the exchange rate past a record low of 4 per dollar in a matter of days and adding further pressure on Rousseff.

“Our Latin American neighbours, with their house in order, have much better conditions to handle this. We don’t,”  said Zeina Latif, chief economist at Brazilian brokerage and asset managment firm XP Investimentos.

Where could a stronger dollar fuel inflation faster? According to Credit Suisse economists led by Daniel Chodos, the so-called inflation pass-through is quickest in Chile and Peru, countries with many goods and services priced in dollars. In Brazil, it is high and persistent, but has a lag, and in Colombia, it is slow but steady. Mexico has the lowest pass-through. Mind those differences and be ready to ride a wave of potential rate hikes across the region.

“In Colombia, the un-anchoring of inflation expectations could be the trigger for the central bank to increase the policy rate in 2015, especially if core inflation indices continue to increase. In Peru, we believe the central bank will increase the policy rate in the short term to anchor inflation expectations,” the Credit Suisse analysts said in the note.

Should we worry about inflation pass-through, Chodos asks in his note. His answer is yes.

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