Why emerging market central banks may begin rate cuts by mid-2023

The central banks' lack of understanding about the non-monetary components of inflation in times of war and crisis is reflected in its policy.

Emerging market monetary tightening cycles seem to have drawn to a close or, at least very close to doing so, months before their developed market counterparts doing the same, an economist at Capital Economics said.

“Policymakers in some EM ‘early hikers’ (such as Brazil and the Czech Republic) have pushed back against expectations for rate cuts, but it still seems likely that on balance, EMs will be easing monetary policy by the middle of the year,” Shilan Shah, Deputy Chief EM Economist, wrote in an investor note.

“The overarching message from the recent spate of EM central bank meetings is that the curtains are coming down on their tightening cycles,” he said.

Mexico’s central bank last week sprang a surprise with a larger-than-expected rate hike but could hike the rate only once more. Interest rates were left unchanged in Romania and Peru, confirming an end to their rate hike cycles. The Indian central bank raised the rates yet again but is widely expected to pause them going ahead.

This follows the recent trend seen in South Korea, Indonesia and Malaysia.

EM central banks not driven solely by US Fed

The Federal Reserve’s influence on the EM monetary policy has waned over the past few decades given the shift to floating exchange rates, the reduction in external risks and the increase in the share of borrowing denominated in local currency, according to Shah.

“This time round, central banks in Emerging Europe and Latin America made much earlier starts to their tightening cycles. They didn’t wait to see if the inflation shock was ‘transitory’ and they hiked aggressively. As a result, policy rates are already well above neutral levels,” he said.

Asian central banks joined the party later than other EM regions, but the rise in inflation there has been less severe, even relative to DMs.

These factors have meant that EM hiking cycles have generally drawn to a close earlier than in developed markets.

There are increasing concerns about economic growth given the global slowdown.

As such, EM central banks will start loosening policy from around the middle of 2023 as growth weakens and inflation continues to fall back, even if it does remain above target in many places.

“Central banks in the Czech Republic, Chile and Korea are likely to be first off the mark. That would be a few months earlier than when we expect cutting cycles in DMs to begin in earnest,” he said.