Smaller Economies in Latin America and Caribbean Face a Bigger Inflation Challenge

IMF News, September 19, 2022

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Analysis focuses on recent inflation dynamics for three sub-groups of small economies in Latin America and the Caribbean (LAC): Central America, Panama, and the Dominican Republic (CAPDR); the Caribbean; and the smaller economies in South America—Bolivia, Ecuador, Paraguay, and Uruguay.
Core finding: high inflation poses a bigger challenge in smaller economies because they are less diversified, rely more on imports, and have more limited policy levers.

During the first half of 2022, inflation reached multi-decade highs in many of these countries.
Latest available inflation data for August:
- Yearly headline inflation exceeded 9 percent in CAPDR.
- Yearly headline inflation exceeded 6 percent in the smaller economies of South America.
- In the Caribbean, it reached almost 6 percent in March.
Core inflation stayed at lower levels than headline inflation (core strips out food and energy prices).
Smaller economies have larger shares of food and fuel in the consumption basket, both of which experienced large price increases since the beginning of the war in Ukraine.
Pass-through estimates for fuel:
- Pass-through from international to domestic fuel prices declined from about 1 before the war (domestic prices moving almost one-to-one with international prices on average during 2015-2021) to about 0.8 after the start of the war.
- A similar decline observed in the smaller countries in LAC.

Less economic diversification and greater reliance on imports increase susceptibility to higher import prices.
Many small LAC economies have less flexible exchange rate arrangements; they rely less on exchange rate adjustments.
Many small countries have high public debt and elevated sovereign spreads, partly a legacy of the COVID-19 pandemic.
Higher public debt limits fiscal space and policy options.

The poorest households have been hit the hardest, driven largely by rapid increases in food prices.
Inflation estimates across income quintiles in CAPDR show the poorest quintiles have faced considerably higher inflation rates than the richest quintiles over the past few months.
Food insecurity, which had already increased during the pandemic, may worsen.

Many small economies implemented discretionary fiscal policy measures to mitigate higher global energy and food prices; most measures were announced as temporary.
About half of the discretionary fiscal measures were targeted to the most vulnerable.
Countries with larger pre-existing subsidies tended to introduce smaller new measures.
The size of new fiscal measures tended to be larger where:
- Food and transportation have larger weights in the CPI basket,
- Social safety nets are weaker,
- Income per capita is lower.
Few of the small economies increased policy rates to contain second-round effects and keep inflation expectations anchored.
Currency pegs in many small LAC economies reduced policy flexibility to address the price shock.

Policymakers should prepare for a possible long-lasting inflationary shock. General principles recommended:
- Domestic prices should adjust to international prices, while providing targeted and temporary support to the most vulnerable.
- If targeted measures are not feasible, price smoothing mechanisms with clear exit strategies could help while social safety nets are strengthened.
- Consider offsetting revenue or spending measures to limit overall fiscal impact.

By Emine Boz, Ilan Goldfajn, Jaime Guajardo, and Metodij Hadzi-Vaskov; September 19, 2022