Peak Inflation May Hint at Peak Rates in Emerging Markets

Central banks across emerging markets (EM) have reacted to elevated inflation by significantly tightening monetary policy, in some cases well ahead of the U.S. Federal Reserve and the European Central Bank. Now, after a challenging period, EM inflation appears to be abating, with policy rates approaching previous cycle highs. This is lifting real, or inflation-adjusted, interest rates above neutral policy rates and toward prior peak levels, potentially creating a more favorable investing backdrop.

After largely synchronized rate-hiking cycles across EM, monetary policies could once again begin to diverge among individual countries. With real rates rising and valuations improving, we see more reason for optimism, though we remain cautious pending greater clarity on the Fed’s hiking path, given the outsized influence U.S. monetary policy has across EM.

Most EM countries have recently seen lower sequential monthly inflation readings. These are expected to decline further into year-end as growth slows and after commodity price increases have recently abated, even as the outlook for energy prices remains uncertain. This lower inflationary path follows from the early hiking cycle in many EM countries, such as Brazil and Chile, which started raising rates in 2021. By contrast, the Fed only began raising rates to tame inflation in March of this year.

For many investors, the discussion on EM policy is becoming more nuanced, moving from how high rates will go to whether EM central banks can hold rates steady (albeit at elevated levels) as the Fed continues to hike. In some EM countries, such as Brazil, local curves have even started pricing rate cuts into late 2023.

Real rates are now above the neutral – or equilibrium – level in most EM countries (see Figure 1). Looking ahead, with inflation expected to decline, those real rates are poised to rise significantly as long as policy rates stay where they are. That scenario appears increasingly likely as inflation expectations remain above many central banks’ inflation targets through 2023 in EM and developed markets alike.

Figure 1: Real rates are above neutral in many major EM economies and near previous cycle highs

This is a bar chart comparing real rates, previous cycle highs, neutral rates, and expected real rates at the end of 2023 across eight EM economies. It shows rates are above neutral levels and near previous cycle highs in Brazil, Mexico, Colombia, and Hungary, while rates in Chile are above both neutral levels and prior cycle highs. Rates are below neutral in South Africa, Indonesia, and Poland.Image Pop Up