Why did many emerging market central banks begin rate cuts?

There was a 100-bps rate cut in Chile last week

>> How can central banks contribute to the fight against inflation?

There was a 100-bps rate cut in Chile last week, with the reduction not just being more than the 75-bps expected but also the first in the cycle as it starts to unwind the 1075-bps of rate hikes that started back in the middle of 2021. The market sees Chile cutting more, and amongst other emerging market countries in the region, such as Mexico, Brazil, and Columbia, the average rate cut is expected by the market to be some 425 bps over the coming year.

In contrast, North American advanced-country central banks in the US and Canada are priced to cut rates by just an average of 24 bp over the coming year. Back in Europe, developing countries such as the Czech Republic, Hungary, and Poland are priced for an average rate cut of 338 bps over the next year, while advanced European countries such as the euro zone, the UK, Switzerland, Norway, Sweden, and Denmark are seen, on average, lifting policy rates by 18 bps.

In short, emerging market countries, at least in these two regions, are broadly expected to start reducing rates sooner and by much more than developed countries. Of course, many of these developing countries have hiked rates by more than their advanced-country peers in the past, but, even so, the large size of the rate cuts anticipated still suggests to us that investors are pretty confident that emerging market central banks will be able to cut hard and fast and won’t have to worry too much that this could create financial tensions, most notable currency weakness. Is this wise, and could central banks like Chile be tempting fate if they go too far ahead of the Fed?

In the Standard Bank's view, there seem to be a number of reasons why there’s little to fear in emerging market central banks running far ahead of developed central banks such as the Fed and ECB.

First, we have to remember that soaring inflation has been and still is largely a developed world problem, not a developing world issue. This is because the source of the inflation problem has morphed from the constrained supply of goods (which affected all countries) through the pandemic and the early stages of the Ukraine conflict to lofty service sector inflation that has come about because of tight labor markets and the rise in wages. Given that this tightening of labor markets is essentially a developed world problem, it clearly means that inflation is more persistent here and less so in emerging market countries.

>> Impacts of sharp rate hikes from central banks

A second point is that many developing-country central banks started to tighten before developed-country banks, and this too has arguably helped the inflation fight. This brings us on to the third reason, which is that the surge in developed-country rates, particularly the Fed, did not lift their currencies dramatically against EM countries. This hints that investors have been pretty cool about their responses.

A fourth factor is that hopes for a soft landing in the US are rising, and in this context, it seems much more likely that developing countries will be able to cut rates quickly without undue currency costs.

Yet another factor is that surveys tend to suggest that global investors still have quite light allocations towards emerging markets, possibly because they feared that rising US rates would do more damage to EMs than we’ve seen. Right now, there seems to be some scrambling to rectify this, and it could help EM currencies should central banks decide to cut policy rates significantly.

Now, clearly, for all these positive reasons why emerging market central banks should be able to cut rates without fear of first-mover currency punishment, there are still risks. That might be because EM central banks move too quickly, but it would seem more likely if the Fed had to re-start a determined rate-hike cycle, which we doubt.