EM FX: The importance of a currency for inflation - Rabobank

Piotr Matys, EM FX Strategist at Rabobank, explains that inflation in emerging economies tends to be significantly influenced by the exchange rate, especially when a country imports most of its energy needs.

Key Quotes

“The latest example is Turkey where consumer prices accelerated sharply to a 14-year high last year. While higher food prices were a major source of inflationary pressure, the plunged in the value of the lira to a record low against both the US dollar and the euro made a substantial contribution to the headline inflation.”

“In December inflation eased from 12.98% y/y to 11.92% y/y, but that was higher than the consensus expectation of 11.85%. More importantly, the core measure increased to 12.30% y/y from 12.08% y/y driven by the ongoing negative impact of a weaker currency.” 

“We expect Turkey’s central bank to retain its hawkish bias after inflation ended last year well above the official 9.8% y/y target and scope for prices to fall in the coming months may prove limited.” 

“Providing the lira with sufficient support will be crucial to bring inflation lower. Turkish policy makers led by Governor Cetinkaya opted for a relatively modest 50bps hike in the late liquidity window lending rate to 12.75% on December 14. With inflation in a double digit territory real interest rates are not adequately high to substantially boost lira’s status of a high yielding currency.” 

“Another factor conspiring against Governor Cetinkaya is a gradual process of monetary policy normalisation by major central banks. The Fed intends to deliver three hikes this year (that said our Fed watcher Philip Marey expects only two hikes) and the ECB may join the Fed in ending the era of QE later this year.” 

“The prospect of the ECB not extending its asset purchasing programme beyond September and perhaps signalling that a rate hike in 2019 cannot be excluded would leave the lira particularly vulnerable against the euro, which would have serious inflationary consequences for Turkey.” 

“Given that at this stage CBRT’s end of 2018 target set at 7% does look ambitious, the bias is skewed in favour of further tightening to provide the lira with a layer of insulation from higher rates in developed economies.”