Emerging markets warned of rapid rate cuts until inflation is brought under control

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

After a round of squeezing to tackle galloping inflation Fueled 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 spur weak growth. But analysts warn that cutting too soon will backfire on developing economies.

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

Analysts say inflation is rooted in structural issues, such as a labor shortage in Central Europe and the use of indexation in Latin America, in which contracts such as leases are automatically adjusted for higher prices. Wage inflation is high in both regions.

Falling energy prices helped grab headlines inflation down. In Brazil, the headline rate fell from 12% last year to just over 4% last month, within the central bank’s target range.

But core inflation, which excludes volatile items such as energy and food, has declined more slowly, as last year’s global commodity price spike spilled over into services and wages. Core inflation in Brazil is over 7%. Wages rose 13% in the year to March, according to the most recent data.

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As price hikes become more widespread, people expect inflation to remain high, which exacerbates challenges for policymakers.

“Central banks aren’t fooled by lower interest rates but are eyeing high drawdowns for core and services,” said Alberto Ramos, Latin American economist at Goldman Sachs. “They give a better idea of ​​the strength and intensity of the pressures.”

Despite these pressures, some policymakers in Latin America and Central Europe – many of whom were among the first to raise rates – are eager to revive growth. Hungary’s central bank cut its main policy rate by 1 percentage point last week to 17%, despite headline inflation of 24% in April. Core inflation was higher, at almost 25%. Wages rose about 17 percent in the year to March.

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

“It is far, far too early for the central bank to consider easing.”

Larose pointed out that Hungary was pursuing “high-pressure” fiscal policies, such as household energy price caps, aimed at “stimulating growth at all costs for populist reasons.”

Unlike Hungary, Polish policymakers have stressed that interest rates will have to stay high until inflation is brought under control. Poland’s main core inflation index shows that it is below the headline rate, although an alternative index that excludes other volatile elements shows it more than a point higher, at 15.3% in april.

Emerging market policymakers were the first to hike rates as the lifting of Covid lockdowns boosted demand and inflationary pressures. Brazil’s central bank began to rise in March 2021, a year before the US Federal Reserve’s first hike. Despite political pressure to cut, he kept the rate of 13.75% reached last August.

William Jackson, chief emerging markets economist at Capital Economics, said persistently high wage growth in Central Europe and Latin America is “one of the big unknowns” for policymakers. While he expected more central banks to start cutting spending this year, he said policy would be eased “more gradually” than expected.

Over the next 12 months, Hauner predicted that interest rates would be cut by less than market prices indicate in Hungary, the Czech Republic, Peru, Mexico, Colombia and Chile. In Brazil, he saw room for a little more slack than the roughly 2.5 percentage points cuts that were priced in.

He said rates should stay high “for at least a few years, to get 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] anytime soon.