Do emerging markets have an inflation problem?

After reaching a trough of 2.2% year-on-year (y/y) in the first half of the year, data released during the past week showed that a simple-average of consumer price inflation across major emerging markets (EM) has risen for three successive months to 3% in August. Inflation rose in roughly half of the major EM markets that we tracked last month, and is currently above central bank targets in several countries including India and Mexico.

Central banks across the emerging world responded to the collapse in economic activity in the first half of the year by slashing interest rates. Some even took the once unthinkable step into the realms of unconventional monetary policy. The recent increase in inflation, coupled with a rebound in economic activity, raises questions about whether markets are too complacent in expecting rates to remain very low for a long time.

We are not unduly worried. There is potential for near-term inflationary pressure from food and energy components. However, we think large swathes of spare capacity in many EM economies will keep a lid on core prices (ex food and energy prices) and anchor headline inflation at relatively low levels.

How rising inflation has eroded the allure of EM currencies

EM central banks are still very much in loosening mode. But when looking at the simple average from 18 of the largest economies, it is notable that the recent increase in inflation has caused real policy interest rates to turn negative for the first time in more than a decade (Chart 1). The real rate is the interest rate less inflation.

Investing in local EM currencies has traditionally been a play on the relatively high carry on offer. The typical strategy seeks to benefit from borrowing in a lower yielding currency and investing the proceeds in a comparatively higher yielding currency. It seems intuitive that further increases in inflation could unsettle investors.

In a best case scenario, that might lead to increased volatility in markets. However, there are many examples in the past where more severe market pressure has ultimately forced policymakers to reverse course, and raise interest rates in spite of weak economic activity.

Why has EM inflation been on the rise?

In order to assess the outlook for EM inflation, it is first important to understand the causes of recent increases. One way to do this is to split inflation into three components. The first two are food and energy, which tend to have relatively high weights in EM consumer price index (CPI) baskets, and where price movements are in large part a function of global commodity prices. The third component is core inflation, which tends to be driven more by the dynamics of domestic supply and demand.

It is always hard to generalise across the disparate group of countries that make up EM. But as Chart 2 shows, much of the recent inflationary pressure has come from a slight increase in food inflation and more recently some reversal of the deep disinflation in the energy segment. The latter has come after the collapse in oil prices earlier this year has begun to wash out of the annual rate of change.

Could a pull-back in food inflation dampen the effects of rising energy inflation?

Futures contracts imply only a gradual increase in the price of Brent crude from around $39 per barrel as at 15 September, towards $45 per barrel in the next 18 months. This suggests that, assuming constant exchange rates, the energy component will continue to put upward pressure on EM headline inflation into the middle of next year (Chart 3). Given that energy inflation typically accounts for 5-10% of EM CPI baskets, this could add somewhere in the region of 0.8-1.6 percentage points to headline inflation.

By contrast, it seems unlikely that food inflation will continue to climb. There is admittedly some risk that various extreme weather events will lead to poor harvests in key countries and put pressure on wholesale food prices. Indeed, the recent discovery of a case of swine flu in Germany is a reminder of the surge in pork inflation in China last year. Nonetheless, there is a reasonable relationship between the lagged changes in global soft commodity prices, gauged here with the S&P GSCI Agriculture and Livestock Index converted into local currency, and EM food inflation.

While the relationship in Chart 4 is clearly not perfect, it does not point to a major run-up in food inflation and even suggests that there could be some decline from current levels in the months ahead. Given that food tends to account for up to 15-25% of EM CPI baskets, even just a 1% y/y decline in inflation can have a meaningful impact on the headline rate.

Why there is ample spare capacity to anchor core inflation

That being said, the outlook for core inflation, which accounts for the lion’s share of CPI baskets, will clearly be the most important determinant of where EM inflation heads in the months ahead and we believe that the outlook is fairly benign.

The reason for this is quite simple: most EMs have suffered deep recessions as a result of measures imposed to contain the outbreak of Covid-19, while relatively weak public finances mean few are able to replace that lost demand with huge fiscal stimulus packages like those seen in developed markets and China. So while most economies have rebounded strongly as containment measures have been relaxed, beyond the short-term release of pent-up demand growth is unlikely to be strong enough to quickly use up the spare capacity caused by the downturn.

The spare capacity in EM economies that lingered after the Global Financial Crisis anchored core inflation at relatively low levels for much of the past decade. Supply bottlenecks caused by supply chain disruptions as a result of lockdowns could distort prices in the near term. But taken at face value, this suggests that while core inflation is unlikely to follow output gap estimates all the way down, there is a good chance that is will remain in a range of 2-3% for some time.

The upshot is that EM inflation is likely to remain relatively low over the next few years. If history is any guide, then clearer evidence of a cyclical upturn in the global economy may give rise to some increase in short-term bond yields. However, it seems unlikely that central banks will come under much pressure to tighten monetary policy in the foreseeable future. Indeed, some such as those in Mexico and Russia should ultimately find more room to cut rates which may lend further support to local currency government bonds.