Emerging markets warned against swift rate cuts until inflation is under control

Tight labour markets and loose fiscal policies will prolong inflation in some developing countries, warn analysts, with underlying price pressures remaining stubbornly entrenched even as food and energy prices fall from last year’s highs.

After a round of tightening to tackle soaring inflation fuelled by the lifting of Covid-19 restrictions and Russia’s full-scale invasion of Ukraine, politicians and some central bank policymakers are keen to cut interest rates quickly to boost weak growth. But analysts warn that cutting too soon will backfire on developing economies.

“In monetary policy, [showing] resolve up front saves you more pain later,” said David Hauner, head of emerging market cross-asset strategy at Bank of America Global Research. “If you let go too early, you have to go back and inflict more pain [by raising rates again].”

Analysts say inflation is being entrenched by structural issues, such as a longstanding shortage of labour in central Europe and the use of indexation in Latin America, in which contracts such as rental agreements are automatically adjusted in line with higher prices. Wage inflation is high in both regions.

The fall in energy prices has helped to bring headline inflation down. In Brazil, the headline rate fall from 12 per cent last year to just over 4 per cent last month, inside the central bank’s target range. 

But underlying core inflation, which strips out volatile items such as energy and food, has fallen more slowly as last year’s global surge in commodity prices feeds through into services and wages. Core inflation in Brazil is running at more than 7 per cent. Wages rose 13 per cent in the year to March, according to the most recent data.

As price rises become widespread, people expect inflation to stay high, exacerbating the challenges for policymakers.

“Central banks are not fooled by headline rates moving down but are looking at high prints for core and services,” said Alberto Ramos, Latin American economist at Goldman Sachs. “They give a better idea of how strong and intense the pressures are.”

Despite such pressures, some policymakers in Latin America and central Europe — many of whom were among the first to raise rates — are eager to kick-start growth. Hungary’s central bank reduced its main policy rate by 1 percentage point last week to 17 per cent, despite headline inflation running at 24 per cent in April. Core inflation was higher, at almost 25 per cent. Wages rose about 17 per cent in the year to March.

Thierry Larose, senior portfolio manager at Vontobel, speaking before the cut, said the central bank’s dovish stance was “very concerning”.

“It is way, way too early for the central bank to think of loosening.”

Larose highlighted Hungary for pursuing “high-pressure” fiscal policies, such as household energy price caps, aimed at “boosting growth at any cost for populist reasons”.

In contrast with Hungary, policymakers in Poland have stressed that interest rates will have to remain high until inflation is under control. Poland’s main index of core inflation shows it to be lower than the headline rate, although an alternative index that strips out other volatile items shows it more than a point higher, at 15.3 per cent in April.

Emerging market policymakers were the first to raise rates as the lifting of Covid lockdowns boosted demand and inflationary pressures. Brazil’s central bank began increasing in March 2021, a full year before the first rise from the US Federal Reserve. Despite political pressure to cut, it has retained the rate of 13.75 per cent hit last August.

William Jackson, chief emerging markets economist at Capital Economics, said persistent high wage growth in central Europe and Latin America is “one of the great unknowns” for policymakers. While he expected more central banks to begin cutting this year, he said policy will be loosened “more gradually” than anticipated.

Over next 12 months, Hauner predicted interest rates to be reduced by less than market prices indicate in Hungary, the Czech Republic, Peru, Mexico, Colombia and Chile. In Brazil, he saw room for a bit more loosening than the roughly 2.5 percentage points of cuts that have been priced in.

He said rates would have to stay high “for a couple of years at least, to bring inflation back to where it should be”.

Many countries, he warned, will have to get used to rates at levels last seen before the 2008-09 financial crisis.

“We are not going back to the pre-Covid paradigm [of very low interest rates] any time soon.”