Inflation dynamics in Latin America: Lessons from the COVID and other episodes

The recent surge in inflation has posed significant challenges to macroeconomic management in Latin America. This paper empirically analyzes the factors driving inflation dynamics in the region post-COVID, highlighting key differences from previous episodes and advanced economies.

The analysis aims to address the following questions: First, what are the recent empirical trends in inflation dynamics in Latin America, and how do they compare with those in advanced economies? Second, what factors drove inflation in Latin America during the recent episode, and how do these drivers compare with those in advanced economies? Specifically, what roles did inflation expectations, exchange rate depreciation, demand pressures, and global supply disruptions play in the rise of inflation in Latin America? Third, what role has monetary policy played during the COVID period and beyond? To what extent does the inflation response to economic policy in Latin American economies differ from that observed in advanced economies? 

The analysis leads to three main conclusions. First, it highlights a gradual convergence of inflation in Latin America over recent decades, shifting from historically higher rates and greater variability towards the more stable patterns observed in advanced economies. This trend, except for energy inflation—which has been notably more stable in Latin America—became increasingly evident leading up to and during the pandemic period. During 2021 and 2022, the increase in CPI components in Latin America mirrored trends in advanced economies, though with some differences. Notably, inflation in Latin America accelerated earlier than in advanced economies in 2021, with Chile, Brazil, and Colombia experiencing double-digit inflation rates. Despite this intensity, inflation has declined rapidly in Latin America since mid-2022.

Second, the magnitude of core inflation acceleration in Latin America was more intense after 2020 compared to advanced economies, and the composition of its underlying factors also differed. During 2021-2023, inflation in major Latin American countries was more influenced by demand pressures and global supply chain disruptions than in previous periods or in advanced economies. Exchange rate depreciation exacerbated core goods and services inflation during 2021-2023 in both advanced and Latin American economies. However, Latin American economies experienced more significant currency pressures during COVID-19, which may explain the earlier acceleration of inflation in the region. Additionally, inflation expectations became less well-anchored during 2021-2023, with Latin American expectations being more affected by demand pressures, exchange rate depreciation, and global supply disruptions than in the past. These results underscore the non-linear features of inflation dynamics during the COVID episode, suggesting that elevated inflation expectations amplify the propagation of various shocks.

Third, monetary policy in Latin America is more sensitive to inflation expectations and demand pressures (as captured by the output gap) compared to advanced economies. This sensitivity explains the faster and more intense increase in monetary policy rates observed in Latin America during 2021-2022. Additionally, the influence of the U.S. Federal Funds rate on Latin American monetary policy is more pronounced than in advanced economies. Specifically, when the U.S. adjusts its monetary policy, it becomes more challenging for Latin American countries to implement a coherent policy in the opposite direction. This dynamic contributes to the slower normalization of monetary policy rates in Latin America since mid-2022, relative to what would be dictated solely by internal macroeconomic conditions.

Read the full paper here.