Emerging central banks feel inflation pain

Finding themselves at the sharp end of a global inflation shock, emerging market central banks are expected to raise interest rates at a pace not seen in more than a decade -- moves bound to aggravate debt problems and hurt equity markets.

Soaring price pressures have seen rate hike expectations shift up even for central banks in the United States, Australia and Britain. The subsequent rise in global borrowing costs will be highly unwelcome to developing countries, many of which are struggling to return to pre-pandemic economic output levels.

Battling soaring food and energy costs, many emerging central banks are already in aggressive rate-hike mode.

And as policy tightening expectations rise for the United States, Britain and other advanced nations, money markets are wagering emerging markets will have to ramp up the hiking pace.

“Many emerging markets are in an increasingly difficult spot,” said Manik Narain, head of emerging market strategy at UBS, pointing to expectations that the current inflation shock would prove to be far more permanent in developing economies than in the United States or Europe. “Markets are pricing in a much faster tightening cycle in emerging than in developed markets, it’s a difficult balancing act.”

South Africa, Mexico, Poland and Turkey are all expected to raise rates by more than 200 basis points in the coming 12 months, JPMorgan calculates. Latin America will see some of the biggest increases, with Brazil expected to hike by more than 600 bps and Colombia more than 400 bps.

Data shows price pressures outstripping interest rates in a number of big economies including South Africa, Mexico, Brazil and Turkey. Across all regions, underlying inflation trends are rising strongly. Mexico’s core inflation posted its highest biweekly increase for a first half of October since 1999 while Russia’s inflation soared to near 8 per cent despite bumper rate hikes.

And with droughts haunting big agricultural producers such as Mexico and Argentina, food inflation is at the forefront of policymakers’ minds, says UBS’ Narain.

“If we start to see a lot of pressure from food prices, policy makers will find themselves in a very tight spot.”

Possibly money markets are being too exuberant. Barclays head of economics research, Christian Keller, expects emerging as well as developed market central banks to deliver fewer interest rate hikes than priced, but he warned nonetheless that “when your inflation expectations start to deteriorate, that is when you need to act as a central bank”.

It is a replay of the age-old conundrum for emerging markets - the need to tighten policy just as economies need extra support.

Preserving a real yield differential over US Treasury yields is also needed to keep foreign investors in domestic markets and prevent capital outflows. Swift central bank action may have helped keep many emerging currencies on a relatively steady footing in 2021, helping cap imported inflation.

So in a year when the US dollar has appreciated almost 5 per cent, the Brazilian real, backed by a cumulative 575 bps in rate increases, has lost more than 8 per cent while the rouble has actually firmed 3.2 per cent on 325 bps of rate hikes.

“Hiking early not only helped with the inflation side of things, but also helps prevent a 2013-taper tantrum style scenario, and certain central banks have gotten on top of this and seen their currency do okay,” said Robert Ojeda-Sierra at Fitch Ratings.

In contrast, markets that haven’t adjusted their monetary policy enough have suffered: Turkey’s lira, hit by interest rate cuts in the face of high inflation, has dropped more than 20 per cent this year.