Why Latin American central banks follow Fed closely?

Andres Velasco, currently Dean of School of Public Policy at the London School of Economics in this piece:

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 signaled 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.

Hmm.. Old habits die hard…

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