BIS study links domestic uncertainty to Latin American output contraction
A new Bank for International Settlements (BIS) working paper reveals that domestic economic policy uncertainty causes significant macroeconomic disruptions in Latin America. The study, covering Brazil, Chile, Colombia, and Mexico, finds this leads to output contraction and rising inflation.
Dual channels of disruption
The study reveals that domestic uncertainty shocks lead to significant macroeconomic disruptions, manifesting as output contraction and a rise in inflation, similar to a supply shock.
These adverse effects are transmitted through two primary channels.
In the short term, a financial channel operates via higher risk premia, increased equity market volatility, and exchange rate depreciations.
Over the medium term, a real channel transmits the shocks through declines in growth expectations, as well as reduced consumer and business confidence.
The research further indicates that these uncertainty shocks inflict the most damage when an economy is already weak or facing tight financial conditions, while stronger economies demonstrate a greater capacity to absorb such impacts.
Isolating domestic pressures
The research specifically focuses on isolating the impact of domestic economic policy uncertainty (EPU) in emerging market economies, using Latin America as a key case study.
Given the region's high exposure to global developments, the methodology involved adjusting the domestic EPU measure to exclude foreign sources of uncertainty.
The study assesses the average impact of these domestic uncertainty shocks across four Latin American countries – Brazil, Chile, Colombia, and Mexico – over a 20-year period from 2005 to early 2025. Furthermore, it delves into the heterogeneous effects of domestic uncertainty by analyzing both downside and upside risks associated with tail events, providing a nuanced view beyond average impacts.
A crucial, yet limited, insight
This BIS study provides crucial clarity by isolating domestic uncertainty, a long-standing challenge for policymakers in emerging markets.
While its findings offer valuable insights into transmission channels, the limited scope to just four countries suggests broader applicability needs further validation.
For regional central banks, the emphasis on economic strength as a buffer against shocks underscores the importance of robust policy frameworks.