Central banks in America and Europe just recently shifted their focus from boosting economic recovery to combating relentless inflation. This change started extensively earlier in several developing markets. Fifteen months before the Federal Reserve did the same thing, in March 2021, Brazil’s central bank increased interest rates by three-quarters of a percentage point. It anticipated that fiscal stimulus in the developed world would increase the danger of inflation, concerning financial markets and making life hard for emerging economies.
Russia’s Central bank Governor Elvira Nabiullina issued a warning more than a year ago, stating that the likelihood of sustained inflation was greater than initially thought. She pointed out that the coronavirus pandemic had altered consumer spending habits. No one knew if the shift would last. However, businesses were reluctant to invest because of this uncertainty in order to meet demand.
The statements of this nature appear prudent and foresighted. With a few notable exceptions, emerging market central banks have gained more credibility in recent years. They now have better monetary policy frameworks, according to a new index designed by the IMF. Their conceptual frameworks are more transparent, consistent, and coherent.
According to the World Bank calculations, in 2005–18, inflation expectations in emerging markets were about as well-anchored as they had been in wealthy nations in 1990–2004.
The sensitivity of inflation to changes in the currency rate also decreased. A sign in front of a café in the Malaysian state of Penang in 2015 is what your columnist recalls. “Don’t worry! As our ringgit falls, the coffee price remains the same,” it said.
Many expected emerging markets to succeed in their battle against inflation, which in turn made success more likely. This increased credibility opened up appealing opportunities. Perhaps their central banks wouldn’t have to worry about every depreciation and every jump in inflation like those in the rich world. If so, they might be able to pay less slavish attention to two variables that have plagued them in the past: the Fed-determined global price of capital and the price of commodities.
For emerging markets, trouble has frequently followed when the Fed tightens monetary policy. For instance, in 2013, Ben Bernanke’s comments about slowing down (or tapering) the rate at which the Fed was purchasing bonds provoked a “taper tantrum” that resulted in a significant sell-off in Brazil, India, Indonesia, South Africa, and Turkey. In a rich world, things are different. British, Euro area and Japanese central banks do not feel compelled to hike interest rates when the Fed tightens. Their currencies might decline. However, they are overlooked unless these depreciations appear likely to raise inflation constantly above their targets.
The expense of living also rises when the price of oil increases. However, unless individuals demand higher wages in return, pushing prices even higher in a self-reinforcing spiral, consumer prices need not continue to rise. Central banks are free to disregard a one-time price hike in both scenarios. The more firmly ingrained inflation expectations are, the more freedom central banks have.
Anchors in emerging markets have been put under a lot of stress during the past year. As the Fed struggles to pass its own credibility test, interest rates throughout the world have increased in anticipation of a stronger pace of tightening in the United States. In addition, food and fuel prices in emerging countries have increased rampantly, accounting for a larger portion of consumer spending there than in the developed world. Food and energy make up more than 60% of South Asia’s consumer price index, according to the World Bank.
The rise in the cost of food and fuel has been seen through certain central banks. As an example, consider the central bank of Thailand, which has done nothing as inflation has skyrocketed. It aims to ensure that the economic recovery picks up steam and maintains anchored medium-term inflation expectations. However, before their economies completely recovered, other emerging markets, such as Mexico and Brazil, felt driven to increase interest rates forcefully.
According to Lucila Bonilla and Gabriel Sterne of Oxford Economics, they responded more quickly than their counterparts in mature economies.
However, that’s partly because they had to be. They had to tighten to keep up with the unsettling increase in inflation expectations. They have remained ahead of the curve. But the curve has been incredibly steep.
Andrew Tilton and his Goldman Sachs colleagues noted that the Fed has been a “somewhat less dominant” force in this emerging-market tightening cycle than in the past. There has not been a second taper tantrum as expected.
Ms. Bonilla and Mr. Sterne point out that several countries that might normally be vulnerable to Fed tightening, like those in Latin America, are also significant commodity exporters who have benefited from increasing prices for their goods.
However, the Fed is far from done. Also, as inflation in emerging countries continues to rise, it could become more susceptible to any declines in local currencies.
According to banker David Lubin of Citigroup, “it’s like adding fuel to a fire.”
It might need more than just a depreciation to start inflation. A weaker exchange rate, however, might increase the heat once it has already started to burn. A Malaysian café that has already changed its rates to keep up with more expensive commodities may be more likely to do so.
Therefore, a lot relies on how far the Fed needs to go in order to restore its reputation as an anti-inflation credential and control pricing pressures in America. The more difficult it is for the Fed to uphold its own credibility, the more difficulties developing markets will face.
Compared to America, they started their hawkish pivot considerably earlier, but it is unlikely to end much sooner. The emerging markets have been reminded this year that despite their gains, they still lack fully credible central banks. America has learned the same lesson from it.
The United States previously experienced extreme inflation in the 1980s, when the situation was deemed to be so serious that the Federal Reserve, which was headed by Paul Volcker, raised interest rates by as much as 3 percentage points.
That pace is roughly six times that of a rate-hiking cycle where the Fed increases rates in steps of 0.25 percentage points.
Former Federal Reserve Board senior official Donald Winn told Paul Volcker at the Fed meeting in March 1980 that “unless we respond to the increase, which could be quite large in this period, we’re going to have a real credibility problem.”
Ultimately, the main interest rate set by the US Central Bank was about five percentage points higher than the inflation rate. The rise caused a severe recession, but eventually, the goal was achieved because inflation shortly started to decline.
The gap between inflation and the federal funds rate today is similar, but the relationship is reversed.
Although several governors of the US Central Bank have talked down the chance of a 1 percentage point rate hike, indicating their preference for a 0.75 percentage point hike, Fed officials are concerned as inflation surged to a fresh four-decade high of 9.1 percent last month.
The federal funds rate would increase in response to such a move to a range of 2.25% to 2.5%, which would be at least 6 percentage points lower than the headline inflation rate at the time.
Fed officials issued their fresh quarterly economic forecasts last month and the members of the Federal Open Market Committee (FOMC) desire the federal funds rate to be at 3.4%. And by year-end, inflation is predicted to be at 5.2%.
The key point is that Fed officials aren’t responding with quite the same urgency as they did during the Volcker era. Eminent economists say that’s a risk.
During an interaction with CoinDesk, Michael Feroli, chief U.S. economist at JPMorgan, said, “We’re as close to an inflation emergency as we’ve been anytime in the past 40 years. The only thing that’s keeping it from being a full-blown, no-holds-barred emergency is that longer-term inflation expectations still seem reasonably well anchored.”
The dynamic is being keenly observed in the bitcoin (BTC) market, in part due to the recent correlation between US stocks and the price performance of the largest cryptocurrency by market size. Investors will find bonds more appealing if interest rates rise faster. Higher borrowing costs will reduce business profits and sluggish investment will have an impact on stock prices.
Pantera Capital CEO Dan Morehead recently argued that the gap between inflation and the federal funds rate is the biggest it has ever been. Prior to the COVID pandemic, when inflation was at 2.3%, the rate was where it is today.
Fed fears losing credibility
The concern of losing credibility could be another danger of the Fed’s soft approach.
The Fed’s recent innovation of using forward guidance to prepare and manage markets for impending rate hikes only functions as long as investors have faith that officials will follow through.
Former Fed official Vincent Reinhart, who’s now chief economist and macro strategist at Dreyfus and Mellon, said, “Powell really, really hates surprising markets. He wants to control the narrative, and he wants to make sure there’s no surprise.”
Recently, a higher-than-expected inflation report caused Fed members to abruptly change their minds about the level of increase in the rate at the last minute.
Speaking about the Fed, JPMorgan’s Feroli said, “I think they probably got some blowback from what appeared to be a bit of choppiness in the last meeting. It didn’t appear that there was a steady advance, and I think to go from 75 to 100 basis points may appear choppier. More unstable, perhaps.”
Making decisions constantly before the FOMC meetings further reduces the significance of the two days of closed-door talks.
According to the reports from CoinDesk, Reinhart said, “The FOMC wants to do multiple things, and they’re not all mutually consistent. You want guidance, you want to convey what you’re going to be doing with rates to investors so they can price it in advance. On the other hand, you also want to be responsive to incoming information. If you give guidance that is not described by the incoming information, what do you do?”
“If you change the plan between meetings, are you respecting the consultations of the committee?” he questioned.
According to Feroli, if things go as per the Fed’s plan, inflation will slow down ultimately in the fourth quarter and if the officials’ forecast proves to be accurate, by the end of the year the rate of federal funds will be as high as 3.5%.
“So at least in quarterly sequential annualized terms, you will get back to a positive real fed funds rate by the fourth quarter, if not sooner,” Feroli concluded.