Monetary policy through COVID-19: Pushing on a string – the case of Latin America and the Caribbean Central banks throughout the world implemented an array of monetary policies to fight the COVID-19 crisis. In contrast to some advanced economies, in response to negative shocks in the past, emerging economy central banks tended to increase policy interest rates as sharp exchange rate depreciations and pass-through pushed inflation higher.1 During the COVID crisis, however, central banks in many emerging economies reduced policy interest rates to close to an effective lower-bound (see Figure 1). They also provided substantial liquidity, especially to banks and to governments (Aguilar and Cantú 2020, Nuguer and Powell 2020). Central banks and governments worked
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Monetary policy through COVID-19: Pushing on a string – the case of Latin America and the Caribbean
Central banks throughout the world implemented an array of monetary policies to fight the COVID-19 crisis. In contrast to some advanced economies, in response to negative shocks in the past, emerging economy central banks tended to increase policy interest rates as sharp exchange rate depreciations and pass-through pushed inflation higher.1 During the COVID crisis, however, central banks in many emerging economies reduced policy interest rates to close to an effective lower-bound (see Figure 1). They also provided substantial liquidity, especially to banks and to governments (Aguilar and Cantú 2020, Nuguer and Powell 2020). Central banks and governments worked together with the common objective of supporting economies.
Figure 1 Policy interest rates in Latin America and the Caribbean
Source: IDB staff calculations based on central bank data.
Note: The figure does not incorporate the 25 basis point rise in the policy interest rate in Mexico on 24 June or in Chile on 14 July.
In this column, we trace the main policies of central banks in Latin America and the Caribbean (LAC) through the COVID crisis. Our contribution is to detail, employing a common framework, how balance sheets expanded as a response to the crisis. We argue some central banks went beyond accommodating the increased demand for liquidity, inducing monetary injections that then returned through excess bank reserves and sterilisation liabilities for those central banks that fixed an interest rate, and through sales of international reserves for those that favoured stable exchange rates. We conclude by outlining selected risks confronting central banks for the months ahead.2
Given the high level of economic uncertainty induced by the pandemic, there was a substantial increase in the demand for liquidity in LAC as in other regions. Figure 2 graphs the trajectory of monetary aggregates through the crisis. Households, firms, and banks sought to exchange illiquid assets (e.g. long-term investments) for liquid ones (e.g. cash and short-term deposits) to keep funds safe and to pay obligations through the crisis. Central bank actions more than accommodated this rush for liquidity. Apart from reducing policy interest rates, virtually all central banks lowered the rates of required reserves on bank deposits. Central banks also found other ways to boost liquidity, depending on their ability to conduct different operations under their respective charters. The mechanisms varied across countries but many extended credit or repo’s to banks and bought government securities on secondary markets. Most central banks in the region are restricted from otherwise lending to the private sector or financing fiscal authorities. In turn, banks increased credit to the non-financial private sector in most countries and bought government bonds in some. Bonds as a percentage of total assets rose on bank balance sheets (Cavallo and Powell 2021).
Figure 2 Stock of M2
Source: IDB staff calculations based on IMF and central banks' data.
Notes: The figures plot the estimated residuals in each country from the regression
relative to the estimated error in February 2020, where bt is the linear trend and d_i are monthly dummies. The sample period in each country starts in December 2008.
These policy measures, together with the greater demand for liquidity, resulted in the expansion of the balance sheets of the central banks in the region. Table 1 ranks a group of countries by the maximum expansion of central bank balance sheets through the crisis, in percentage points of 2019 GDP, and computed as the cumulative variation in total assets (which by definition is the same as that of liabilities plus net worth). For Brazil, Chile, and Peru, the central bank balance sheet expansion was well in excess of 10% of GDP, approaching that of some advanced economy central banks.
Table 1 Maximum cumulative variation in the balance sheets of central banks in 2020-2021 (% of 2019 GDP)
Source: IDB staff calculations based on IMF and central banks' data.
In both Chile and Peru, the central bank provided substantial liquidity to the domestic financial system. In Chile, the central bank bought bonds issued by banks while banks bought government bonds and boosted credit to the non-financial private sector, backed by a substantial public sector guarantee scheme. In Peru, the central bank extended repos to the banks and allowed guaranteed bank loans to firms to act as collateral. This may have sharpened the incentives for banks to lend to firms with partial guarantees. In the case of Brazil, an exchange rate depreciation resulted in an increase in the value of international reserves in local currency on the asset side and an increase in the net worth of the central bank. New legislation allowed the central bank to pass some of that increase in net worth to the government, which was then transferred to a deposit account of the government at the central bank. As the government drew down its deposits for COVID-related spending, the central bank issued sterilisation liabilities.
Several central banks pushed these measures to the limit. Policy interest rates were lowered to an effective lower bound. Central banks injected liquidity through lowering required reserves on deposits and through asset purchases (some to purchase foreign currency from external debt issuance).3 Still, in the end it is households, firms, and banks themselves that decide how much liquidity they are willing to hold. In several countries, policy interest rates acted as a floor system, and the excess liquidity returned to the central bank (Resinek 2019). Highly liquid banks started to increase their reserve holdings at the central bank and to purchase sterilisation liabilities. As the old adage goes, at the limit monetary policy becomes “pushing on a piece of string” – a phrase often ascribed to both Keynes and the Federal Reserve Chair, Marriner Eccles, in the 1930s (see also the continuing discussion regarding the efficacy of quantitative easing).4
Looking forward, there are several potential risks depending on the underlying scenarios for the health crisis and economic recovery. One risk is that as demand recovers, even as fiscal impulses are reigned in, supply remains constrained, and prices are pushed higher. This has already happened in some countries, led by rises in the price of food. Brazil is a case in point and the central bank has already reacted, increasing the policy interest rate by 225 basis points since March 2021 – and has signalled that further rate rises might be forthcoming.
One view is that such price rises should be temporary and, while inflation may be pushed above the inflation target, it should come back down without the need for central bank action. However, this presupposes inflation expectations will remain anchored to a fully credible target despite central bank inaction. Emerging economies may not be able to afford to take such risks. Mariscal et al. (2016) find that if inflation runs above target, then there may be a price to pay, as expectations for Latin American inflation targetters may become de-anchored. Moreover, given the calibration of a dynamic stochastic general equilibrium (DSGE) model for Latin American countries in Cavallo and Powell (2018), the growth impacts of a rise of policy rates may be relatively muted while the impact on inflation is relatively strong. In other words, the action tends to work, and the costs may not be so great. Perhaps this risk of somewhat higher inflation as recovery takes hold with a normalisation of interest rates is a good problem to have. Still, Treasury-Central Bank tensions may arise if the latter sees fit to tighten monetary policy, raising the cost of short-term domestic government debt.
Perhaps of greater concern, however, is a scenario in which vaccine roll-out is slow and the spread of new mutations prolongs the health crisis, delaying recovery and requiring greater fiscal spending, while at the same time there is a change in the patient stance regarding monetary policy in the US. On the one hand, this would create the need for greater fiscal financing, but on the other hand may limit access or increase the cost of that financing in international markets, especially for those countries where debt has risen more strongly, and financing requirements have soared.5 While central banks and governments worked together closely to support economies during 2020, in this scenario tensions might arise. There might be greater pressure to seek new ways to finance fiscal spending – either by adopting more creative accounting under current legislation or even attempting to change central bank frameworks. A persistent monetary financing of deficits could create the conditions for higher inflation, which may be costly to bring back down. The region’s history amply demonstrates the risks (see the various chapters in Kehoe and Nicolini 2021). Central bank independence and the quality of balance sheets going forward are key to avoiding these inflationary risks.
A further potential risk relates to the stock of short-term sterilisation liabilities on the balance sheets of central banks. These are mostly in local currency and central banks appear to have ample buffers of international reserves to back the commitments. But some governments are also faced with considerable debt service obligations coming due, and central banks may need to resist sharp depreciations (which would boost the value of buffers in dollars relative to these local currency obligations) given inflation objectives and corporate debts in dollars. The dual treasury and central bank roll-over risks should therefore be closely monitored.
Authors’ note: The views are strictly those of the authors and do not necessarily represent the views of the Inter-American Development Bank or any other institution. The authors wish to thank Salim Syed Chanto, Santiago Novoa Gomez, and Carlos Guevara for excellent research assistance.
Aguilar, A, and C Cantú (2020), “Monetary policy response in emerging market economies: why was it different this time?”, BIS Bulletins 32, Bank for International Settlements.
Cavallo, E, and A Powell (2018), A Mandate to Grow, Latin American and Caribbean Macroeconomic Report, Washington, DC: Inter-American Development Bank.
Cavallo, E, and A Powell (2021), Opportunities for Stronger and Sustainable Postpandemic Growth, Latin American and Caribbean Macroeconomic Report, Washington DC: Inter-American Development Bank.
Kehoe, T J, and J P Nicolini (2021), A Monetary and Fiscal History of Latin America, 1960-2017, University of Minnesota Press.
Mariscal, R, A Powell, and P Tavella (2018), “On the Credibility of Inflation-Targeting Regimes in Latin America,” Economia 18 (2): 1-24.
Nuguer, V, and A Powell (2020), Policies to Fight the Pandemic, Latin American and Caribbean Macroeconomic Report, Washington, DC: Inter-American Development Bank.
Resinek, M (2019), “Floor versus corridor systems in monetary policy regimes Overview of the euro area experience and forward-looking issues”, 13th ECB Central Banking Seminar.
Powell, A (2017), “Inflation targeting and interest rate procyclicality in the UK and in Latin America”, VoxEU.org, 25 November.
1 Having said this, on 2 Nov 2017, the Bank of England tightened in the face of the Brexit shock and a plummeting pound (Powell 2017).
2 This column draws on material from Chapter 4 in Cavallo and Powell (2021).
3 Interestingly, while there was concern about strong portfolio capital outflows at the start of the crisis, there was substantial international bond issuance by sovereign and corporates from Latin America and the Caribbean. Most countries retained access to international capital markets and at the same time current accounts deficits narrowed. In aggregate, international reserves rose although there was some heterogeneity across countries – see Cavallo and Powell (2021) for a more detailed analysis.
4 The Federal Reserve Chair was known as the Governor before 1935. While overall measures of liquidity may eventually be endogenous, there may be impacts on specific markets and on credit (e.g. Kapoor and Peia 2021).
5 Debt rose from 58% of GDP in 2019 to 72% of GDP in 2020 for Latin America and the Caribbean and in a central scenario may rise to 76% of GDP by 2023. Total financing requirements (interest plus amortisations) on public debt are about 5% of GDP for 2021 or about double the investment on infrastructure in previous years (Cavallo and Powell 2021).