Perspective

When will emerging market inflation peak?


Bond markets in the emerging world have been rattled by rampant inflation. There may a bit more pain in the near term. That said, with the peak in inflation coming into view and expectations for growth starting to roll over, opportunities may be starting to emerge for investors.

Emerging market central banks are taking action

Inflation is above target and rising in the vast majority of major emerging markets (EM) that we track. Unlike in developed markets, where policymakers are deliberating over what are in the grand scheme of things small tweaks to monetary policy, their EM counterparts are busy aggressively raising interest rates.

Just in the past month, the central banks of Brazil, Chile, the Czech Republic, Poland and Russia have delivered large, consensus-busting rate hikes. Meanwhile, the market has moved to price in yet more substantial tightening that would lift rates to pre-pandemic levels in many EM. 

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Could emerging market inflation be close to peaking?

There is probably some more pain to come in the near term. For example, leading indicators point to a further increase in food inflation into the new year and thereafter much will depend on market variables. The recent spike in fertiliser prices portends another leg up in global food prices while a stronger US dollar could yet hit EM currencies. As the green line in the chart below shows, such developments would push EM food inflation higher for longer and add to the headache for policymakers.

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However, fertiliser prices have not always been a reliable guide to future food prices. And there is a good chance that EM currencies will strengthen now that a lot of water has passed under the bridge with regards to the slowdown in China’s economy and, in particular, US Federal Reserve tightening.

Movements in food prices work through economies with different lags. In general though, a period of stability should be enough for food inflation to drop away next year and knock 0.5-1.0 percentage points off average EM inflation. A decline in global food prices would be even more favourable if it were to happen.

It is a similar story when it comes to the energy component of inflation. A few months ago we reviewed the implications of higher oil prices and inflation in emerging markets. We flagged that an increase in oil prices would slow the decline in EM energy inflation, and with Brent trading at above $80 per barrel it will take a bit longer to ease.

Meanwhile, the crisis in European gas markets is an added inflationary pressure for central and eastern Europe. But for most EM, barring another major increase in fuel prices, energy inflation should drop away and this generally accounts for 5-10% of consumer price index (CPI) baskets.

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Of course, core inflation – in other words everything else apart from food and energy – accounts for the lion’s share of CPI baskets. Like in developed markets, core inflation has been on the up in most EM, as frictions in the reopening of economic and global supply chains adds unanticipated pressure to the price of many goods. However, pandemic-induced stimulus measures were generally far less generous in EM.

The interest rate hikes already in place will sap demand with a lag of six to nine months, and inputs such as higher producer prices that have pushed up core inflation may be starting to turn down.

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Further signs that inflation will cool next year, at a time when growth expectations are rolling over, might ultimately mean that central banks do not deliver all of the tightening now priced into markets. This could present opportunities for investors.