The debate around whether recent spikes in inflation data are temporary or signaling the beginning of a more long-term phenomenon is central to the performance of local currency emerging market debt (EM). Central bank policy responses are key to determining EM vulnerability and performance over the medium term. However, base effects make it more difficult to determine whether recent price increases are temporary or not. In this post, we present a simple framework to help identify which central banks are taking a prudent stance and proactively moving to contain inflation and those that are not.
While inflation prints have recently come in well above inflation targets in many EMs, we would argue that the recent year-on-year prints are not an adequate gauge of inflationary pressures. These are backward-looking measures and heavily influenced by base effects due to last year’s drop in consumption given the lockdowns implemented to combat the pandemic (Figure 1).
FIGURE 1
Inflation Prints Skewed by Base Effects
Bloomberg, PGIM as of June 2021.
Therefore, we devised a simple framework to more accurately analyze whether central banks are proactively moving to avoid the propagation of these price pressures by hiking policy rates, or whether they are not and consider the recent spike in inflation as merely temporary.
Accounting for Base Effects
Our framework involves a two-step approach. First, we compared a central bank’s current policy rate to the country’s average Q2 2021 inflation estimate. Figure 2 shows the lenient approach taken by most central banks, most notably by those in Central and Eastern Europe. However, the base-effect bias is still present.
FIGURE 2
Policy Rates Lag Recent Inflation Estimates
Haver, PGIM as of June 2021.
We then annualized the most recent three-month inflation rate (a proxy for inflationary pressure) and compared it to the actual year-over-year inflation for the same period. Figure 3 plots the difference between the annualized three-month inflation rate and actual inflation rate against the change in central bank policy rates over the last three months.
FIGURE 3
Some Central Banks More Proactive than Others
Haver, PGIM as of June 2021.
If three-month annualized inflation is higher than the last observed year-on-year inflation and the central bank had hiked its policy rate recently, we categorized the central bank as being more proactive, or orthodox. Put differently, this response indicates that the central bank is taking appropriate measures to ensure that recent spikes in inflation do not spread to other sectors of the economy.
The implications of the varied policy responses in Figure 3 warrants additional comments. Some Central European central banks that have clearly lagged in their responses to recent inflation spikes have started to slowly hike rates recently. Additional caveats apply—for example, inflation in South Africa is inching up, but remains well within the central bank’s inflation target corridor.
An Orthodox Approach is Preferable
We grouped the central banks in our sample into three categories: the “low inflation” banks (China, Indonesia, Korea, Malaysia, Philippines, and Thailand), the “reluctant hikers” (India, Poland, Romania, Chile and Colombia), and the “orthodox” banks (Brazil, Russia, Czech Republic, Hungary, Mexico, Turkey, and South Africa). We then checked whether the market expects each to maintain the same stance in the coming months by calculating the market-implied real policy rate for the end of 2021 by subtracting the Bloomberg consensus inflation forecast for Q421 from the nominal market-implied policy rate. The results are shown in Figure 4. Our analysis shows that the market expects most of the central banks in our sample to hike their nominal policy rates, but only a few to end up with a positive real rate.
FIGURE 4
Few Central Banks Expected to End 2021 With Positive Real Policy Rates
Bloomberg, PGIM as of June 2021.
The central banks in Russia and Brazil are the most proactive, while the stances of the of the “reluctant hikers” signal some cause for concern as their policy stances are not expected to change significantly. Despite the frequent headlines, Turkey’s central bank is not too far behind the curve. Some other countries (e.g. Czech Republic, Hungary, and Mexico) have recently started to cautiously hike rates, although more action appears to be needed in the Czech Republic and Hungary.
When it comes to EM central bank policy responses, we think orthodoxy is good. While premature rate hikes may hamper economic recoveries, particularly in EM countries where COVID cases are still rising, a more proactive approach may head off the need for more aggressive action in the future. Countries that appear to be moving most proactively to contain inflation are likely to present better risk-reward opportunities than those that are not. Based on this framework, currencies and (once the rate hiking cycle is close to the end) local bonds associated with Brazil and Russia appear attractive, while those of Central Europe, Chile, and Colombia may lag.
