MercoPress. South Atlantic News Agency

Uruguay’s interest rates hike “will aggravate stubbornly high inflation”, anticipates CE

Wage indexation and capacity constraints keep Uruguay business costs elevated

The latest Uruguayan central bank decision to further hike interest rates is “unlikely to do much to tackle stubbornly high inflation” and contrary to this could end acting as a magnet for foreign capital inflow, “aggravating the very problem it seeks to address”, says Michael Henderson from Capital Economics.

Last Friday’s decision to raise interest rates by 25bps to 9% came as “a surprise” because the consensus among experts was that it was to be left at 8.75% for a third successive meeting.

Inflation in Uruguay remains uncomfortably strong and has been “extremely slow to fall back and at 7.9% in August remains a long way from the central bank’s target of 4% to 6%”, says the report on Uruguay.

And according to Capital Economics inflation in Uruguay can not be attributed to overheated domestic demand but to structural factors: wage indexation is high even by regional standards and capacity constraints in the local market keep business costs elevated. Furthermore the high level of dollarization (over 50% of banking sector deposits) limits the effectiveness of monetary policy.

“In the absence of a large shock to demand, we doubt that inflation will return to its 5% target either this year or next. Even in 2008-09, headline CPI failed to drop below 5.9% y/y. What’s more, the recent expiration of a power saving scheme will put upward pressure on utility bills in the coming months” anticipates Capital Economics.

The report then points out that “paradoxically, higher interest rates might even make the inflation problem worse. Uruguay now holds the dubious title of the highest nominal policy rate in the region which, combined with a recent upgrade to investment grade status, makes the nation highly attractive to foreign investors seeking yield. To the extent that rising foreign capital inflows stoke credit growth, this could end up pressuring inflation higher – a concern that led the central bank to hike foreign and local currency reserve requirements in July”.

Finally bringing down inflation on a sounder permanent basis will require labour market reforms aimed at restructuring wage arrangements, as well as tighter fiscal policy and infrastructure improvements. These are all medium-term policy objectives.

Since the Uruguayan government priority seems to be keeping the economy expanding at a fast rate, Capital Economics believes inflation will remain steady above target and rates on hold at 9% well into 2013.

Policymakers feel that higher grain prices, an improvement in global risk appetite and tentative signs of a recovery in Brazil and Argentina have all alleviated the near-term external risks to Uruguay’s economy.