With the arc of the hiking then easing cycle by the United States Federal Reserve, Morgan Stanley noted that emerging market (EM) central banks have had to balance domestic concerns against foreign exchange considerations.

In Latin America, central banks had early and aggressive hiking cycles. Now, complex domestic fiscal policies have combined with exchange rate considerations to make the inflation path more challenging, said the bank.

The push and pull of domestic and external factors are highlighted by the contrasting policy paths of the central bank in Brazil (BCB) and Mexico (Banxico), stated Morgan Stanley. Higher rates have come back to haunt Brazil while Banxico is hinting at perhaps more-aggressive cuts.

On the back of a weaker currency, fiscal uncertainty and stronger economic growth pressuring inflation forecasts, the BCB raised rates by 25bps in September after being on hold since May. Inflation expectations have risen further away from the target, and hawkish speeches have signaled even more hikes going forward, which is the reason why Morgan Stanley sees an acceleration of the hiking pace to 50bps in November.

In total, the bank estimates the BCB to hike rates by 200bps this cycle. Fiscal uncertainty is the main risk to the call: the administration continues to focus on measures to raise revenues to improve fiscal accounts, with members of Congress signaling that they aren't willing to raise taxes.

The BCB has already stressed concerns about fiscal dynamics and its impact on asset prices and as such Morgan Stanley infers that less fiscal consolidation will lead to more monetary policy restraint to tame inflationary and currency pressures.

Things have been different in Mexico, where Banxico has started an easing cycle that will likely have a series of rate cuts. A majority of board members see real rates as too high, considering the progress on disinflation and a weaker growth backdrop. The bank predicted continued 25bps cuts in the near term, even though some policymakers have hinted that more aggressive cuts could be debated in coming meetings.

Morgan Stanley thinks the recent peso (MXN) depreciation will keep Mexico's policymakers cautious, delivering 25bps cuts for now. Pausing at this time isn't a likely option, barring a rapid depreciation but rather, risks to the call are tilted towards an acceleration of cuts, a scenario that would likely follow a more aggressive Fed easing.

The reversal of the policy path by the BCB provides a cautionary tale for other central banks in the region, added Morgan Stanley. In Colombia, the fiscal outlook is also worsening, which will give BanRep a reason to ease less than it might otherwise. Indeed, one of the deputy governors said in public remarks that it wished to avoid following the BCB's example of cutting and then having to reverse course.

So far, the BanRep board has largely focused on core services disinflation to accelerate the pace of easing, but it's the fiscal outlook that leaves the bank expecting only a 50bps cut at Thursday's meeting.

In Chile, Morgan Stanley keeps its call for a BCCh 25bps cut at the December meeting, despite less benign external conditions through the recent peso (CLP) depreciation. Weak economic activity, benign inflation prints in the past few months and anchored inflation expectations support the idea that authorities can and will bring policy rates to neutral into next year.

On the fiscal front, while rating agencies have flagged concerns, Chile continues to have one of the lowest debt levels in the region, making it less likely to be subject to external concerns that could pressure the currency lower.

All told, with Morgan Stanley's current view that developed market central banks except the Bank of Japan will continue easing through the first half of next year, Latin American central banks largely have room to ease policy, as well.

However, the divergence trade will come down to the differences in their domestic situations, including actual and perceived risks to the fiscal outlook, according to the bank.