Emerging market central banks are about to get active

Summary

We believe emerging market central banks are on the cusp of initiating, or in select cases continuing, monetary easing cycles. Our Mid-Year 2023 Outlook publication highlighted this view; however, our updated monetary policy space framework reinforces this outlook and confirms that many emerging economy central banks have space to cut interest rates before the end of this year. With that said, we believe financial markets are priced for too much easing. So, while we forecast emerging market currency depreciation through the end of 2023, markets adjusting to more cautious easing cycles should contain the extent of depreciation and result in only modest EM FX weakness through the end of this year.

Emerging market central banks have policy space for rate cuts

The International Economics Mid-Year 2023 Outlook focused on our view that the global economy is at an inflection point. In our opinion, conditions are evolving in such a way where global growth has peaked and the direction of monetary policy is set to change. We spoke at length about the Fed and G10 central banks approaching the end of their respective tightening cycles; however, we also highlighted how institutions across the emerging markets will be making a more explicit shift toward easier monetary policy in the second half of 2023. This idea comes from the fact that many emerging economy central banks tightened monetary policy earlier and more aggressively than institutions in the advanced economies. Early and aggressive inflation fighting action have yielded positive effects as inflation, both headline and core, are now on sustainable downward trajectories for most countries in Latin America, EMEA and emerging Asia. Improving inflation dynamics have already led to select institutions initiating easing cycles, and the evolution of broader economic and financial market conditions over the first half of this year lead us to believe more EM central banks will actively pivot to interest rate cuts before the end of this year.

While we already forecast many EM central banks to begin lowering policy rates in the near future, we have updated our monetary policy space framework for more visibility into the dynamics policymakers are likely to consider when setting interest rates. Our framework contains four variables: real interest rates, inflation relative to central bank target ranges, economic growth and local currency performance. We define “real interest rates” as the current policy rate minus actual inflation. Typically, the more positive a real interest rate is, the more space a central bank has to lower interest rates. “Inflation from central bank target” utilizes a forward-looking assessment of year-over-year CPI and how far inflation is expected to be from target ranges by the end of this year. Using a forecast allows us to consider the likely path ahead for inflation—one of key inputs policymakers consider when setting monetary policy—and with inflation currently elevated but heading lower, a forward-looking assessment is more appropriate to gauge possible interest rate adjustments. Our framework also includes a measure of how well the local economy is performing. The growth momentum indicator is designed to gauge whether economic activity is improving, stable, or fading in response to aggressive tightening cycles. Central banks associated with slowing activity are more likely to consider easing, while stable or improving activity may not offer a strong reason for lower interest rates. And finally, our framework incorporates financial market developments. In that sense, we consider local currency performance against the U.S. dollar over the last six months. Currency appreciation—which most of the EM FX complex has experienced over the first half of this year—can be rationale for shifting toward more accommodative monetary policy, while currency depreciation will typically trigger a need for higher interest rates.

We score each of these four variables individually. Without going into too much detail on the scoring system, a green box suggests an indicator adds policy space for a central bank to lower interest rates. An orange box is relatively neutral—offering only limited direction for lower policy rate adjustments —while a red suggests that variable offers policymakers no space to cut interest rates. For example, Chinese real interest rates are positive indicated by a green box in Figure 1, suggesting real interest rate dynamics allow for the People's Bank of China to cut interest rates. Inflation is also below the PBoC's informal 2% target, suggesting space for easier monetary policy given subdued local price pressures. Economic growth momentum has slowed, and as of now, our methodology suggests momentum behind activity offers modest capacity for the PBoC to ease monetary policy. And while the renminbi has trended weaker over the course of the first half of this year, the overall depreciation has not been significant enough for PBoC policymakers to tighten monetary policy settings to defend the value of the currency via higher interest rates. In that sense, FX performance also offers the PBoC modest space to lower interest rates. Ultimately, we aggregate these indicators to get an overall gauge of which institutions currently have space for interest rate cuts in H2-2023. The Q3-2023 Monetary Policy Space column represents those aggregated results. Central banks highlighted in green have adequate monetary policy space—which we define as capacity for more than 50 bps of rate cuts, countries highlighted in orange have limited monetary policy space—defined as scope for 25 bps-50 bps of cuts before the end of this year, while countries represented in red have no space for any easing of monetary policy. We also offer our framework's results from the prior quarter for comparison purposes. As for China, our framework suggests the PBoC can lower interest rates, more specifically bank Reserve Requirement Ratios, by more than 50 bps before the end of this year, capacity that has been in place since Q2-2023.

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