What next for monetary policy in Peru? - Capital Economics
Latin America Economics

What next for monetary policy in Peru?

Latin America Economics Update
Written by Quinn Markwith

Peru’s economy appears to be suffering one of the largest economic hits of any country from the coronavirus, which is likely to spur further policy easing. With short-term interest rates essentially at zero, further monetary loosening would initially probably take the form of strengthened forward guidance. But a quantitative easing programme is also looking increasingly likely.

  • Peru’s economy appears to be suffering one of the largest economic hits of any country from the coronavirus, which is likely to spur further policy easing. With short-term interest rates essentially at zero, further monetary loosening would initially probably take the form of strengthened forward guidance. But a quantitative easing programme is also looking increasingly likely.
  • The statistics office’s economic activity data (which is a good proxy for GDP growth) revealed a 40.5% y/y contraction in April, suggesting that the peak-to-trough fall in GDP will be one of the largest globally. What’s more the latest Google mobility figures suggests that activity remained especially weak in May and June. (See Chart 1.) More economic support is likely to be needed.
  • This could come from the fiscal side – the government has space to add to the 12% of GDP package already in place. On the monetary side, the policy rate has already been cut to 0.25%. Additional easing will have to come via unconventional means, something the central bank has already suggested is possible.
  • A likely first choice would be strengthened forward guidance, such as interest rate projections or stronger commitments to keep rates low that move beyond the current promise to keep policy loose for an “extended period”. If forward guidance is insufficient, another option would be quantitative easing (QE).
  • Many EM central banks announced bond purchase programs in March to ease stress in financial markets. Some, which have taken short-term rates to the zero bound, have now turned to QE programs aimed at lowering longer-term bond yields. Hungary is one example, as – it seems – is Chile. (See here).
  • As with Chile, there is a good case for Peru to use QE to bring down relatively high long-term interest rates. Peru’s local currency sovereign bond yield curve is steeper than in Chile. (See Chart 2.) The 10-2-year yield gap is 2.3% in Chile, and 3.5% in Peru. What’s more, there are relatively few legal barriers to QE in Peru. Peru’s constitution allows the central bank to buy government bonds in the secondary market.
  • Of course, the central bank could decide against QE for other reasons. The expansion of the monetary base could spark inflationary concerns. But the central bank has established its credibility by keeping inflation low over the past two decades. What’s more, Peru’s public finances are very strong, reducing the risk that the central bank would make excessive purchases of sovereign bonds to finance the government.
  • The currency will also be on policymakers’ minds. While it has held up relatively well since the start of the pandemic, the sol has been the worst performing EM currency over the past month (it is down by around 2% against the dollar). The economy is quite dollarised and the central bank has conducted around $1.6bn (0.7% of GDP) in foreign currency sales this year to smoothen currency volatility.
  • That said, Peru’s external position is strong; its current account deficit is small and its foreign exchange reserves are large. The currency is also thinly traded and less exposed to dramatic sell offs. And those EMs that have tried QE recently (such as Hungary) haven’t seen big currency falls. The upshot is that Peru’s central bank has plenty of tools available to bring down longer-term rates and help the recovery.

Chart 1: Google Mobility Trends (Retail & Recreation Visits, Difference vs. Jan 3rd – Feb 6th, %)

Chart 2: Local Currency Sovereign Bond Yield Curve

Source: Google

Source: Refinitiv


Quinn Markwith, Latin America Economist, quinn.markwith@capitaleconomics.com