Emerging Markets | FX | Monetary Policy & Inflation
Parts of emerging markets are starting to see rising inflation. This is the result of earlier currency depreciation, supply-side disruptions and rising food and energy prices. Because of this, many EM central banks are starting to put the brakes on further easing. Two EM central banks have even hiked rates. And with US yields set to remain anchored at very low levels for years ahead, EMFX should benefit.
Grouping EM by Inflation Trends
Inflation trends across emerging markets (EM) are difficult to generalize given large differences in economies, but the COVID pandemic has seen three groupings emerge (Table 1). The first group is most interesting because accelerating inflation has the most significant implications for monetary policy. It contains some of the usual suspects like India, Mexico and Turkey, but also Poland and Hungary. Meanwhile, others like South Africa and Indonesia don’t feature.
Food Matters
A big reason for the inflation in these countries is the rise in inflation in the food component of CPI, as well as the recent turnaround in energy prices. Rising food prices are impacting wider government policy, with Brazil’s President Bolsonaro recently urging supermarkets to reduce profit margins on basic foodstuffs. This follows an earlier suspension of import tariffs on rice. Given the larger weight of food prices in EM inflation baskets versus DM (Chart 2), this is a key reason why the rising inflationary pressures have been concentrated in EM.
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Parts of emerging markets are starting to see rising inflation. This is the result of earlier currency depreciation, supply-side disruptions and rising food and energy prices. Because of this, many EM central banks are starting to put the brakes on further easing. Two EM central banks have even hiked rates. And with US yields set to remain anchored at very low levels for years ahead, EMFX should benefit.
Grouping EM by Inflation Trends
Inflation trends across emerging markets (EM) are difficult to generalize given large differences in economies, but the COVID pandemic has seen three groupings emerge (Table 1). The first group is most interesting because accelerating inflation has the most significant implications for monetary policy. It contains some of the usual suspects like India, Mexico and Turkey, but also Poland and Hungary. Meanwhile, others like South Africa and Indonesia don’t feature.
Food Matters
A big reason for the inflation in these countries is the rise in inflation in the food component of CPI, as well as the recent turnaround in energy prices. Rising food prices are impacting wider government policy, with Brazil’s President Bolsonaro recently urging supermarkets to reduce profit margins on basic foodstuffs. This follows an earlier suspension of import tariffs on rice. Given the larger weight of food prices in EM inflation baskets versus DM (Chart 2), this is a key reason why the rising inflationary pressures have been concentrated in EM.
Weak FX has Driven Inflation Higher
Another driving factor behind EM inflation is the passthrough from the protracted currency weakness earlier this year. BRL, MXN, and TRY fell through Q1 and early Q2, and their effects are still working their way through to import prices. It is striking that even though Brazil is the worst-performing EM currency this year, headline CPI inflation has remained lower than in other EM countries. However, weakness from import prices is showing up in producer prices. The import price component of Brazil’s manufacturing PMI reached an all-time high in August, and Markit commented that ‘short supply of inputs and unfavourable exchange rate factors drove an eye-wateringly high price of input cost inflation’. So, while CPI may be contained for now, there are significant risks around pipeline price pressures that could feed through into consumer prices.
The recent run-up in Mexico’s inflation is also striking. August CPI at 4.05% YoY is up from 2.15% in April and now above the central bank’s 3% target. The main drivers are higher food prices (7% in August versus 5.8% in April) as well as imported inflation from the 20% decline in the peso in Q1. Put another way, it is goods prices where inflation is rising, while (non-tradeable) services inflation remains moderate.
MXN and BRL have partly recouped earlier losses, which should start to ease inflationary pressures. RUB, by contrast, has seen a renewed bout of weakness through Q3 on the back of geopolitical risks, leaving further upside risks to inflation.
Turkey and India have the highest inflation in EM at 11.8% YoY and 6.7% YoY respectively (Chart 1, we exclude Argentina here), and, alongside Mexico, are both above the central bank target. Turkish CPI is down from the 2018 highs as the earlier spike in food prices has eased (in part due to direct government intervention), but ongoing currency weakness leaves significant inflationary risks ahead.
Underlying Price Pressures are Also Rising
Core inflation has also moved higher across EM, particularly in Mexico (3.97% YoY), Poland (4.0% YoY) and Hungary (4.2% YoY). This is due to a combination of rising processed food prices and, in some countries (Poland and Turkey), elevated services inflation. High readings on core CPI will make it more difficult for policymakers to look through the recent run-up in headline CPI, raising concern about the possibility of second-round effects from the higher food, and more recently, energy prices.
The combination of higher core and headline inflation is also starting to push up inflation expectations. The RBI noted the continued rise in both three-month and one-year ahead inflation expectations (to 10.4% and 10.5% YoY respectively) in its latest policy statement, while in Poland the latest NBP minutes highlighted that both consumer and enterprise inflation expectations ‘remained elevated’.
As is Uncertainty Over the Inflation Outlook
Alongside the rise in inflationary pressures, the uncertainty over the inflation outlook has also risen. The IMF recently noted ‘a rise in the variance of expected inflation indicating significant uncertainty and a potential risk of de-anchoring’. Banxico echoed this, with the minutes from the 13 August meeting describing the balance of risks to inflation as ‘uncertain’.
EM Central Banks Now Largely Done with Easing, Two Have Hiked Rates
Last week saw two EM central banks surprise with interest rate hikes. Turkey pushed through a 200bps hike to 10.25% at its scheduled policy meeting, while Hungary increased the rate on the 1-week deposit facility by 15bps to 0.75% just a few days after the MPC had left interest rates on hold. Currency weakness, rising inflation, and for Turkey reserves loss, were the key reasons.
We do not expect other EM central banks to follow with rate hikes but further rate cuts now seem unlikely. Indeed, September saw several EM central banks hitting pause on easing. Brazil’s decision to leave rates on hold came after nine consecutive rate cuts. Meanwhile the on-hold decision from the SARB was in contrast to the consensus call for another rate cut, given subdued inflation and exceptionally weak growth. Russia’s on-hold decision, the result of rising inflation and ongoing RUB weakness, also ended a series of consecutive rate cuts. India’s central bank was scheduled to meet this week, and with inflation remaining above target another hold decision was expected after the pause in easing in August. The meeting has, however, been postponed due to the failure to appoint three new MPC members. Banxico continued with its easing cycle last week despite above-target inflation but the pace of easing was reduced, with a 25bps cut compared with the earlier 50bps cuts.
While Banxico and the RBI may yet push through further small rate cuts, the EM easing cycle is largely over. Some unconventional measures will continue: QE is ongoing in Poland, Bank Indonesia is conducting direct monetization of the fiscal deficit, and the RBI is continuing with ‘operation twist’ to try to push down long-end yields. But as interest rate cuts, rather than balance sheet expansion, have been the dominant force in EM monetary easing, this is an important shift.
EMFX to Benefit from Yield Support
The absence of further rate cuts in EM, coupled with negative real rates in the US for several years to come, should support EMFX. Real rates remain positive in Mexico and Russia, and valuations are attractive. China too has a positive yield differential with the US plus strong fundamentals and a competitive currency. Further dollar weakness will undoubtedly be the driving factor, and, with little reason to expect any reversal in the downtrend, our medium-term view on EM currencies is bullish.
Caroline Grady is a Senior Researcher at Macro Hive. Formerly, she was a Senior EM Economist at Deutsche Bank and a Leader Writer at the Financial Times.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)