Which EM Will Be Next to Hike?

Summary

• Rate hikes from Brazil, Turkey and Russia this week raise the question, which EM country is next?
• India and the Philippines are possible contenders based on inflation. The Czech Republic and South Korea are the two others to watch.
• Near-term inflation increases are already embedded in central bank forecasts given the base effects from high oil prices. Priorities are capping any second-round effects and ensuring inflation expectations remain well anchored.
• China’s focus will likely remain on reining in the earlier credit expansion and pockets of sectoral overheating, not a broad interest rate hike.

Three rate hikes this week by major EM central banks reflect the sharp turnaround in inflation dynamics. A run-up in energy prices in recent months has added to earlier gains in food prices and pushed inflation increasingly above central bank targets. Spiking shipping costs and some shortages in raw materials have also pressured prices. But inflationary pressures are non-uniform across EM. We investigate why, and which other central banks might hike next.

This week’s rate hikes in EM were unsurprisingly where inflation is highest. Turkish CPI is running at 15.6% YoY, Russia at 5.7% and Brazil at 5.2% (Chart 1). Excluding Argentina, BRL, TRY and RUB were also the three worst-performing EM currencies last year, losing between 16-23% versus the USD. Therefore, FX pass-through has been another factor in the move higher in inflation.

The lira and rouble have fared better this year, thanks to Turkey’s shift to a more orthodox policy framework and in Russia’s case higher oil prices. But the Brazilian real has continued to weaken given the combination of political and fiscal risks. This leaves FX pass-through an ongoing upside risk to inflation.

China, by contrast, remains in deflation. Protracted disinflation in food prices and last year’s currency strength are both key reasons. Some softness in domestic demand has probably added to the weakness in prices.

RBI, CNB, BSP and BoK Seen as Contenders for Rate Hikes

In an earlier note, we categorized EM according to inflation:

1. High/accelerating inflation generally combined with FX weakness (Turkey, Brazil, Russia, India, Mexico and Poland),
2. Low inflation or deflation with stable or appreciating currencies (China, South Korea, Taiwan and Singapore),
3. Disinflation with pronounced macro weakness (South Africa and Indonesia).

These groupings still broadly hold today, although discussion on rate hikes mainly centres on India, the Czech Republic and South Korea. Markets are also pricing in rate hikes in the Philippines given the sharp run-up in inflation. Indonesia looks vulnerable to rising US rates given the weaker macro fundamentals and lingering worries over BI independence, yet inflation remains low. Central banks in Mexico and Poland remain dovish with rate hikes far off.

We detail the discussion for rate hikes below, and for Poland and Mexico the arguments against.

India: The fourth-highest inflation rate in EM (5.0% YoY) leaves India a key contender for a rate hike. Market expectations for RBI rate hikes over the next year are around 90bps and therefore higher than for the CNB (81bps) or the BoK (37bps). But we see this as unlikely. India’s earlier disinflation was largely due to a sharp reduction in local food prices. And the recent reversal is due to rising energy prices, with petrol and diesel running in double digits in YoY terms (and at an all-time high in absolute terms). Cuts to last year’s hike in fuel duties are increasingly discussed as a way to rein in energy prices.

The RBI’s 4% +/-2pp inflation target is currently being met. Consensus forecasts see inflation heading lower from here, and our bullish call on the rupee should, if it plays out, help to contain gains in import prices. Inflation expectations are also down from earlier highs, albeit only moderately so. Overall, RBI easing appears finished, but we see rate hikes as some time away.

Czech Republic: CNB forecasts see rates rising from mid-year, and Governor Jiri Rusnok said in late January that the bank could potentially implement two rate hikes this year. At 2.1%, inflation is close to the 2% target but 0.4pp above the latest CNB forecast, and the economy is expected to pick up, despite the COVID-related restrictions. The CNB was in a hiking cycle pre COVID, and a lack of rate hikes elsewhere in Europe will not impede tighter monetary policy, providing current macro dynamics remain in play.

Philippines: A sharp acceleration in inflation in recent months has left markets pricing significant rate hikes from the BSP over the next year. At 4.7% YoY, inflation is above the target band and more than 2pp higher than in October, with food prices up by even more. The central bank is monitoring for second-round effects from what it sees as a transitory supply shock. Should price pressures broaden, however, a rate hike could become unavoidable.

South Korea: Inflation is lower in South Korea at just 1.1%, versus a 2% target. But the combination of won underperformance, improving activity from semiconductor demand, and, like most other countries, an increasingly unfavourable base from rising oil prices has prompted increasing discussion over when the BoK will start to tighten policy. A still-export-dependent recovery and weakness in the labour market suggest the BoK are in no hurry. And we think it would take a fairly significant run-up in inflation from here to prompt the BoK to turn hawkish.

Poland: NBP rate hikes seem highly unlikely despite core inflation remaining elevated at 3.7% YoY. QE is being stepped up, some direct and verbal FX intervention has occurred over recent months to weaken the currency, and the focus is firmly on growth rather than inflation. Also, the NBP’s 2.5% +/-1pp inflation target is being met with headline CPI at 2.4% YoY, and inflation has been within the target range since the start of the pandemic. March forecasts from the NBP also see inflation remaining within the target band throughout the forecast horizon, on an unchanged interest rate assumption.

Mexico: Earlier disinflation is starting to reverse, and CPI could well continue to move higher over the coming months given unfavourable base effects from oil. But unlike the RBI, Banxico was able to continue its easing cycle with a 25bps cut to 4% in February. Banxico has described risks to the inflation outlook as ‘uncertain’ for some time, but the expected Q2 increase in inflation is assumed to be temporary. Consensus forecasts see another rate cut in Mexico with the terminal rate at 3.75%.

EM Inflation Divergence Driven by Differing Food, Energy Weight Plus Idiosyncratic Food Shocks

Differing weights for fuel and food prices across EM also explain why the rise in inflation is non-uniform across countries. Those with high weights for food prices such as India (46%), the Philippines (35.5%) and Russia (29%) are among those with the highest inflation. South Korea, by contrast, has a food weight more similar to the US and euro area at 13%, and inflation there has remained low.

But that fails to explain the deflationary environment in China given the 29% weight on food. There the story is more that the food shock came earlier. Food inflation was in double digits in H2 2019 and peaked at 21.9% in February 2020 (driven largely by a spike in pork prices). Since then, food price pressures have dropped considerably.

Weights also vary on energy, leaving those with higher weights (Brazil and Thailand) more sensitive to rising fuel prices. The pass-through from international to local prices is also country specific, with countries such as Indonesia keeping greater control over domestic prices. With CPI baskets reported differently across countries it is difficult to get a truly comparable read on energy weights. We proxy it below by adding the transport and fuel components, where available. For Turkey, Russia and China this is transport only.

EM Central Banks to Look Through Inflation

Overall, we expect most EM central banks to look through the forthcoming acceleration in inflation. Many central banks have revised near-term inflation projections higher in recent months but expect the rise to be transitory. Focus is therefore firmly on reining in any second-round effects and ensuring inflation expectations remain anchored.

This is more difficult in countries such as India and the Philippines, where inflation is already elevated and weights of volatile components such as food and energy are high. But for now, we expect that Brazil, Turkey and Russia will remain the three EMs in hiking mode.