In financial markets, the question on every investor’s lips these days is when the US Federal Reserve will start dialling back, or tapering, its US$120 billion monthly asset purchase programme aimed at cushioning the economic blow from the Covid-19 pandemic
At the end of its policy meeting on Wednesday, the Fed offered few clues on when it will unwind its bond-buying scheme. While America’s central bank expects to start raising interest rates in 2023, it is under pressure to begin the process of curtailing its asset purchases, given the faster-than-expected rise in inflation
, which could prove longer-lasting than many assume.
Yet, as investors await a decision, a growing number of developing economies have already begun to tighten policy. The shift towards less-accommodative financial conditions began in earnest in China when policymakers took advantage of last year’s swift recovery from the shock of the pandemic to revive the deleveraging campaign
Beijing’s renewed determination to reduce risks in the financial system has accelerated since the end of 2020, with a gradual scaling back of fiscal support and a reduction in the amount of cash in the banking system. The tightening in liquidity has spooked stock markets and driven up interbank lending rates.
Part of the reason China lost control of the post-pandemic narrative
in markets is because of fears it might be tightening policy too sharply. However, in comparison with the stance of monetary policy in some of the other leading emerging markets, China’s central bank is distinctly dovish.
Since March, Brazil’s central bank has raised its benchmark rate by 2.25 percentage points in an effort to curb a steep rise in inflation. That rise reached 8.1 per cent year on year last month, its highest level in five years.
The aggressive tightening has triggered a sharp rally in the Brazilian real, which has outperformed other major emerging market currencies at a time when developing nations face challenges, from delays in deploying vaccines
to a period of significantly slower growth compared with advanced economies.
Russia has also tightened policy sharply this year, raising rates three times to combat a surge in inflation that has climbed above 6 per cent. Other emerging market central banks, notably in Eastern Europe and Latin America, are likely to follow suit.
Although many developing economies are refraining from increasing borrowing costs on the grounds that the rise in inflation
is likely to be temporary and the recovery is too fragile to cope with higher rates, threats to financial stability are more acute in emerging markets.
Even though developing economies’ external imbalances are more contained than in the run-up to the 2013 “taper tantrum
” – the dramatic sell-off in emerging markets caused by Fed hints that it planned to start curtailing asset purchases – local currencies and bonds are at risk.
A report published by Gavekal this month noted that real interest rates in leading emerging markets – mostly in positive territory before the tantrum – are deeply negative, increasing the vulnerability of asset prices in the event of another Fed-induced sell-off.
In some respects, it is reassuring that major emerging markets are taking pre-emptive action to shore up their defences against the risk of a sharper deterioration in sentiment, particularly when there is much uncertainty about the surge in inflation.
Yet, the efficacy and appropriateness of steep rate rises is questionable. In Brazil, one of the countries that has suffered the most from the pandemic and which is struggling to make headway with vaccinations
, forecasts for consumer prices are being revised upwards, not downwards, while market expectations of inflation are increasing, according to Bloomberg data.
Part of the problem is that many key drivers of inflation – the surge in global commodity prices
and, in Brazil’s case, a once-in-a-century drought
that has pushed up electricity prices – are beyond the control of central banks. This makes it more difficult for central bankers to make the case for aggressive rate increases, especially given the pandemic-induced threats to growth.
If the spike in inflation is transitory – which remains most likely in the absence of rapid wage growth – emerging market central banks might be jumping the gun. Still, while it is possible investors are pricing in too much tightening in developing economies, there is also a risk bond markets are too complacent about a Fed policy shift.
The US central bank already expects to begin raising rates earlier than previously forecast, with two increases anticipated by the end of 2023. Even though the Fed wants to avoid another tantrum, it could end up causing one.
Vulnerable emerging markets such as Brazil have little choice but to continue tightening policy to help stabilise markets. If inflation keeps rising sharply, the Fed’s hand might yet be forced.
Nicholas Spiro is a partner at Lauressa Advisory