In Latin America, Fiscal Policy Can Lighten the Burden of Central Banks

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Growth in Latin America is projected to slow to 1.6 percent this year after a remarkable 4 percent in 2022. Price pressures that accompanied last year’s brisk economic activity appear to have peaked, but underlying inflation remains stubbornly high, disproportionally hurting low-income households who spend most of their earnings on food. To mitigate the risk that inflation becomes entrenched, fiscal policy can help monetary policy in reducing demand pressures.

After peaking at 10 percent in mid-2022, headline inflation in the largest Latin American economies has slowed to 7 percent in March. However, this drop mostly reflects the fall of commodity prices from their peaks. Progress in bringing down core inflation, which excludes food and energy, appears to have stalled. Labor markets are tight, with employment firmly above its pre-pandemic levels. At the same time, output is at or above potential, and short-term inflation expectations exceed central banks’ target ranges. Strong domestic demand, rapid wage increases, and broad-based price pressures all point to a risk that inflation in the region could remain unacceptably high.

Tempering demand to tame price pressures

While most countries in the region have made important strides in price stability in the last two decades, the region’s history is full of examples of how high inflation can destabilize the economy and fuel inequality by hurting vulnerable groups most.

Restoring price stability is paramount to a healthy economy and protecting the most vulnerable. In the current juncture, this requires slowing domestic demand. With inflation—and especially core inflation—running considerably above target and economies operating above potential, policymakers no longer face the macroeconomic trade-off of 2021 and early 2022, when fighting inflation was at odds with the need to support the recovery from the pandemic. Policies should be aimed at restraining demand to bring it back into line with potential output. This will inevitably require cooling the labor market.

Decisive central bank rate increases have already done the heavy lifting. Furthermore, the recent financial stresses in some advanced economies could lead to tighter global financial conditions, which will further help cool demand. Given the usual lags between interest rate increases and their effect on economic activity, the full impact of the tightening that has already been undertaken should be seen most clearly during the course of this year, contributing to slower growth this year.

However, with inflationary pressures proving persistent, central banks will need to remain resolute in their fight until there is an unambiguous downward path for prices. Interest rates will likely need to remain high for much of this year and, in some cases, even into next year. This will guide inflation back to target by late 2024 or early 2025.

A more balanced policy mix

To assist central banks in their battle against inflation, fiscal policy could play a bigger role through a more countercyclical stance this year. As recent IMF research shows, fiscal tightening makes it possible for central banks to increase rates by less to bring down inflation.

The fiscal stimulus of 2020, which was essential to support economies during the pandemic, has been mostly withdrawn, but fiscal policy this year is expected to be broadly neutral in most countries. A more contractionary fiscal stance would help slow domestic demand, allowing interest rates to start coming down sooner. This would reduce potential financial stability risks from keeping interest rates higher for longer and help to bring down public debt levels, creating more policy space to respond to the next economic shock. That is, a more balanced policy mix would improve the prospects of taming inflation and reducing the risks of a recession.

Rebalancing policy will not be easy. Demands for social spending in the region are high. There are serious distributional and social equity issues to contend with. Enacting tax policies that require the wealthy to pay their fair share should be part of the solution.

But policymakers will also need to find savings without cutting into key social programs or spending on health, education, and public infrastructure. There is important scope to reduce inefficiencies in public spending, and people are more likely to embrace more prudent public finances if services are provided with greater efficiency. Being good stewards of taxpayer resources could also help reverse the erosion of trust in government that many countries have suffered over the last several years.

This agenda is challenging, but restoring price stability is paramount to protecting the poor and durably addressing social demands. Relying more on fiscal policy in taming inflation makes sense from a macroeconomic perspective and, if policies are well-designed, can be achieved in a socially equitably way.

Asia Likely to See Dynamic Economic Growth, but With Policy Challenges

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By Krishna Srinivasan and Alasdair Scott

Asia and the Pacific remains a dynamic region despite the somber backdrop of what looks to be shaping up as a challenging year for the world economy.

Global growth is poised to decelerate as rising interest rates and Russia’s war in Ukraine weigh on activity. Inflation remains stubbornly high, and banking strains in the United States and Europe have injected greater uncertainty into an already complex economic landscape.

Asia’s domestic demand has so far remained strong despite monetary tightening, while external appetite for technology products and other exports is weakening. We project the region will contribute more than 70 percent of global growth this year as its expansion accelerates to 4.6 percent from 3.8 percent last year.

China’s reopening will provide fresh momentum. Normally the strongest effect would be from demand for investment goods in China, but this time the biggest effect is from demand for consumption. Other emerging economies in the region are on track to enjoy solid growth, though in some cases at slightly lower rates than seen last year.

Even so, the dynamic growth outlook doesn’t mean policymakers can be complacent. Some risks—such as public debt—we have recently discussed (including in our January blog) remain. Intensification of the recent global financial tremors could spark others.

Beyond these risks, persistent inflation remains a challenge. Global commodity prices have moderated after surging last year and supply chain pressures have eased, but inflation remains above central banks’ targets. Core inflation, which excludes food and energy, has also proven sticky.

Output gaps—measures of how closely demand is running to the capacity to meet demand, and hence the pressure on prices—for Asian economies are either narrowing or have already closed, while levels of economic capacity themselves might have fallen as a result of so-called economic scarring from the pandemic.

The effect of currency depreciation against the US dollar last year is still passing through to prices. The impact could be greater than usual, because of the already-high inflation, especially for emerging economies. These factors suggest that the battle to contain inflation isn’t over. With real interest rates still low—and negative in some countries—central banks may need to keep interest rates higher for longer.

The significant uncertainty about the path of global and regional financial conditions presents another challenge. The recent turbulence in some US and European banks serves as a cautionary tale about contagion risks. We have seen how some banks in Europe and the United States have struggled with rising interest rates.

Similarly, banks in Asia—particularly in advanced economies—could suffer losses from increases in wholesale funding costs and sudden declines in the market values of assets. Lenders in some emerging economies could face liquidity stresses following sudden deposit withdrawals or retrenchment in external funding lines. Some countries and sectors are significantly exposed to a sharp increase in external borrowing costs, though these risks have recently diminished somewhat.

Even aside from the potential spillovers from these kinds of external stresses, domestic vulnerabilities are evident. Leverage had increased even before the pandemic. Corporate debt is concentrated in firms at risk of insolvency and in a few sectors, such as property. Real estate prices in Asia are still historically high even after recent cooling; further declines could pressure banks’ balance sheets, especially those exposed to mortgage lending and real estate developers. Asian financial systems should be able to withstand these stresses as they are well capitalized and have strong liquidity buffers, but financial supervisors must be alert.

Fiscal consolidation amid high debt and rising interest rates is another challenge. Public debt levels in the region have increased significantly compared to before the pandemic. Most governments are expected to tighten budgets this year and next. However, the projected consolidation may not be enough to stabilize debt, and rising interest rates would make the burden even heavier.

Finally, there are heightened risks to economic growth in coming years. Although China is expected to rebound this year, it is likely to slow over the medium term, implying the lowest such growth rates for Asia in decades. In addition, China’s growth is likely to shift from investment to consumption. This could have significant implications for the region, especially for economies with sizable exports to China. Greater geoeconomic fragmentation would also add to pressures on growth potential.

What do these challenges mean for policymakers?

The best remedy for financial stress is prevention—policymakers should keep a close eye for stresses and develop contingency plans. Unless strains in financial markets increase and raise broad-based stability concerns, central banks should separate monetary policy objectives from financial stability goals. To do so, they should use available tools—such as lending and discount facilities—to ease any liquidity constraints in the banking sector, allowing them to continue to tighten policy to address inflationary pressures.

Fiscal consolidation may need to be more aggressive to ensure sustainability over the medium term—but policymakers must strike a balance between supporting growth, protecting the vulnerable, and addressing debt concerns.

The region must prioritize policy initiatives that foster innovation-driven economic development. The green transition presents a wide range of innovation opportunities that can become the region’s new growth drivers if leveraged effectively. By investing in research and development, promoting entrepreneurship, strengthening education and digitalization, Asian countries can foster sustainable, long-term growth.