To Hike or Not to Hike? Monetary Policy in Latin America During Fed Liftoff

IMF Blog, October 21, 2015

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Canonical URL: To Hike or Not to Hike? Monetary Policy in Latin America During Fed Liftoff

Publication authors: Carlos Caceres, Yan Carrière-Swallow, Bertrand Gruss
Publication date: October 21, 2015
Core question: As the U.S. Federal Reserve prepares to raise policy rates for the first time in almost a decade, can Latin American central banks keep interest rates low to support domestic activity, or will global rate movements (Fed liftoff) force them to follow?

Decomposition of domestic interest rate movements for 46 advanced and emerging countries into:
- Component reflecting central bank efforts to stabilize output and inflation.
- Residual component comprising other central bank objectives (for example, moderating exchange rate movements for financial stability or competitiveness) and shocks affecting monetary conditions.
Investigation of the extent to which the residual movement can be attributed to spillovers from global financial conditions, such as shifts in U.S. policy rates.

Once domestic macroeconomic conditions are controlled for, spillovers from U.S. rates are smaller than simple interest-rate correlations, but still significant for some countries.
In Latin America, spillovers are significant and relatively large in Mexico and Peru, implying these countries would be less likely to deviate from the Fed’s behavior even if their business cycles were out of sync with the United States.
The impact of Fed lift-off on long-term interest rates depends critically on the factors driving U.S. interest rates, especially the U.S. term premium.
Under the baseline scenario—U.S. rates increase according to current market expectations embedded in futures contracts—the expected impact on Latin America is small.
Certain risk scenarios could produce much larger impacts:
- A faster-than-expected Fed hiking cycle could magnify effects on long-term rates in the region.
- A decompression of an unusually low U.S. term premium back to its precrisis average could cause substantial increases in Latin American interest rates—over 160 basis points in some cases—with important implications for government spending on debt service.
Movements of the magnitude described have been observed several times since 2000, including in the months following the “taper tantrum” episode of May 2013.

Exchange rate flexibility:
- Plays the key role in allowing central banks to orient monetary policy toward stabilizing the domestic economy.
Strength and credibility of policy frameworks:
- Credibility of the central bank’s commitment to price stability reduces spillovers.
- Market perceptions of fiscal vulnerabilities increase spillovers.
Other factors:
- Financial dollarization substantially increases interest-rate spillovers.
- Active use of reserve requirements—one element of the macroprudential toolbox—can help mitigate spillovers to some extent.

Countries with flexible exchange rates and credible monetary and fiscal frameworks should be able to continue providing support by keeping short rates low where needed.
Keeping shorter-term rates aligned with domestic conditions would help cushion the effects of unavoidable increases in domestic long-term rates.
Macroprudential tools (for example, reserve requirements) and policies that reduce financial dollarization and strengthen policy credibility can limit adverse spillovers from U.S. rate moves.

Source: To Hike or Not to Hike? Monetary Policy in Latin America During Fed Liftoff (IMF blog, October 21, 2015).