In america and Europe, central banks turned only recently from encouraging economic recovery to battling stubborn inflation. In some emerging markets this shift began much earlier. Brazil’s central bank raised interest rates by three-quarters of a percentage point back in March 2021, 15 months before the Federal Reserve did the same. It foresaw that fiscal stimulus in the rich world raised the risk of inflation, which would upset financial markets and complicate life for emerging economies. The governor of Russia’s central bank, Elvira Nabiullina, warned over a year ago that the prospect of sustained inflation was likelier “than perceived at first glance”. The pandemic had changed spending patterns, she pointed out. No one knew if the shift would last. But that very uncertainty was discouraging firms from investing to meet demand.
These kinds of comments look prudent and prescient in hindsight. Indeed, with some notable exceptions, central banks in emerging markets have won increased respect in recent years. Their monetary-policy frameworks have improved, according to a new index (based on 225 criteria) developed by the imf. Their frameworks are more coherent (their targets serve sensible objectives), transparent (they say what they are doing) and consistent (they do what they say). According to calculations by the World Bank, expectations of inflation in emerging markets in 2005-18 were about as well-anchored as they had been in rich countries in 1990-2004. Inflation also became less sensitive to falls in the exchange rate. Your columnist remembers a sign outside a café in the Malaysian state of Penang in 2015. “Don’t worry!” it said. “As our ringgit falls, coffee price remains the same.”
More people expected emerging markets to succeed in their fight against inflation, which in turn made success more likely. This enhanced credibility raised enticing possibilities. Perhaps their central banks, like those in the rich world, would not need to worry about each depreciation and every inflation spike. If so, perhaps they could pay less slavish attention to two forces that had bedevilled them in the past: namely, the global price of capital, which is dictated by the Fed, and that of commodities.
When the Fed tightens monetary policy, trouble has often followed for emerging markets. In 2013, for example, Ben Bernanke’s talk about reducing (or tapering) the pace of the Fed’s bond-buying sparked the “taper tantrum”, a big sell-off in Brazil, India, Indonesia, South Africa and Turkey. Things are different in the rich world. When the Fed tightens, central banks in Britain, the euro area and Japan do not feel obliged to raise interest rates. Their currencies may fall. But unless these depreciations look likely to raise inflation persistently above their targets, they are ignored. Likewise, when the price of oil goes up, so does the cost of living. Yet consumer prices need not go on rising, unless people demand higher wages in response, putting further upward pressure on prices in a self-reinforcing spiral. In both cases, central banks can ignore a one-time increase in prices. The more securely inflation expectations are anchored, the more leeway central banks enjoy.
The past year has subjected emerging-market anchors to one severe test after another. Global interest rates have risen in anticipation of a faster pace of tightening in America, as the Fed wrestles with a credibility test of its own. And emerging markets have suffered remorseless increases in the prices of food and fuel, which make up more of their consumers’ shopping bills than they do in the rich world. According to the World Bank, food and energy account for over 60% of South Asia’s consumer-price index.
Some central banks have been able to “look through” the rise in food and fuel prices. One example is Thailand’s central bank, which has done nothing even as inflation has surged. It insists that “medium-term inflation expectations remain anchored,” and it wants to make sure the economic recovery gains traction. But other emerging markets, including Mexico and Brazil, felt compelled to raise interest rates forcefully long before their economies fully recovered. They were quicker to respond than their counterparts in mature economies, point out Lucila Bonilla and Gabriel Sterne of Oxford Economics. But “that’s partly because they had to be.” Much of their tightening had to keep up with a worrying rise in inflation expectations. They have stayed ahead of the curve. But the curve has been brutally steep.
The Fed has been a “somewhat less dominant” force in this emerging-market tightening cycle than in the past, note Andrew Tilton and his colleagues at Goldman Sachs. Fears of a second taper tantrum have not been realised. One reason may be that a lot of footloose foreign capital had already left during the pandemic. Moreover, some of the countries that might otherwise be vulnerable to Fed tightening, especially those in Latin America, are also big commodity exporters that have benefited from higher prices for their wares, point out Ms Bonilla and Mr Sterne.
Following the leader
The Fed, however, is far from finished. And inflation, already rising in emerging markets, may become more sensitive to any falls in domestic currencies. “It’s like adding combustible material to a fire,” says David Lubin of Citigroup, a bank. A depreciation may not be enough to ignite inflation. But once it is already burning, a weaker exchange rate could make it hotter. A Malaysian café that is already revising its prices to keep up with costlier commodities may be more likely to factor in a weaker ringgit.
Much therefore depends on how far the Fed has to go to restore its anti-inflation credentials and contain price pressures in America. The harder the Fed must work to meet the test of its own credibility, the more trouble emerging markets will face. Their hawkish pivot began much earlier than in America, but it probably cannot end much sooner. This year has reminded emerging markets that for all their progress, they are not yet blessed with fully credible central banks. It has taught America the same lesson. ■
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Read more from Free Exchange, our column on economics:
The case for strong and silent central banks (Jun 30th)
People’s inflation expectations are rising—and will be hard to bring down (Jun 19th)
The Fed’s flawed plan to avoid a recession (Jun 14th)