The EM central bank policy response
On the interest-rate front, the combination of stronger economic growth and higher inflation has prompted a number of EM central banks to pivot from cutting policy rates to raising rates instead. The starting point for this new rate landscape was EM policy rates that, until very recently, were mired at historic lows (Figure 2).
Notably, three major EM central banks — Brazil, Russia, and Turkey — have initiated rate-hiking cycles. Barring unforeseen developments, some of their EM counterparts in Central Europe should follow suit in the coming months. Given that inflation has been more contained in Asia so far, rate hikes there are less likely this year, but it’s reasonable to assume the next move in those EMs’ policy rates will be up as well. We view rate hikes from ultralow levels as an effort by EM central banks to narrow the gap between their current policy rates and their estimates of neutral policy rates. In the case of some EMs (Brazil, Turkey, Hungary), recent concerns about currency depreciation have also generated a focus on supporting their struggling currencies.
Looking ahead at this stage, we do not expect policy rates in most EMs to extend much beyond neutral, if at all. Some higher-yielding EMs have been successful in lowering inflation in recent years, thanks to a lengthy period of weak economic growth, which helped keep demand (and thus prices) in check, as well as their central banks’ improved commitment to average-inflation targeting. We believe these factors should help to anchor average inflation at or below target in many EMs next year, potentially slowing or even calling a halt to their rate-hiking cycles. (Due to its unique economic circumstances, Turkey is likely to remain an EM outlier with regard to inflation.)
We also see growing concern among some EM central banks around US Federal Reserve (Fed) policy direction going forward — specifically, the risk that the Fed could fall behind the curve, so to speak, in its inflation-management strategy and be forced to raise its policy rate more quickly than planned. (In part, recent and anticipated EM rate hikes are designed to offer investors a more attractive risk premium until developed market (DM) central banks begin to “taper” monetary policy later this year or early next.) In response to such a US scenario, EMs that have a greater degree of policy flexibility may be inclined to use it in the period ahead to stay competitive as an investment destination.
The Czech Republic is an example of an EM central bank whose solid inflation track record and relative financial stability could allow for unconventional policies. However, the Czech National Bank appears to be more focused on gradually raising its policy rate and on providing scope for stimulus measures to combat the next economic shock, whenever that might be. Other EM central banks — Hungary, Poland, and Israel, along with Indonesia and the Philippines — will have to navigate incremental pullbacks from asset purchases undertaken amid the COVID crisis.