Currency concerns to temper rate hikes

Strong capital inflows continue to create something of a headache for policymakers in Latin America. On the one hand, growth should remain strong over the coming quarters, while the inflation outlook is likely to deteriorate. But on the other hand, rapid exchange rate appreciation has given growth an increasingly unbalanced look: domestic demand is racing ahead, while export-orientated sectors are lagging behind. Hiking interest rates to combat nascent inflation concerns would risk fuelling yet further capital inflows and thus exacerbating the problems caused by rapid currency appreciation. Accordingly fiscal policy and other forms of monetary tightening (such as raising banks’ reserve requirements) will have to shoulder the burden of the adjustment. It goes without saying that against this backdrop, the risk of policy error is high and rising.