Peak inflation? Not yet in the case of emerging markets, it seems

Investors are watching for signs of a slowdown in high inflation rates, but the first set of monthly data for June is not encouraging.

By David Rees, Chief Emerging Markets Economist

David Rees

Inflation in emerging countries seems to have increased further in June. Fears that inflation has yet to peak could increase pressure on emerging assets. With emerging markets already under pressure, investors are increasingly anticipating a global recession.

Overall, inflation beat expectations in the 13 major emerging market countries that released data last week. Based on these early reports, headline inflation in emerging countries appears to have increased further from the 20-year high of 9% reached in May (year-on-year).

We exclude Turkey in this analysis given specific challenges related to a slow balance of payments crisis, which pushed the consumer price index (CPI) up to 80% year on year in June.

2022.07.29.EM inflation

Our regular readers will recall that we entered 2022 expecting a spike in inflation to be the catalyst for opportunity in local bond markets (see When will emerging market inflation peak?). This anticipation was based on the slowdown in the rise in food and energy prices and on the fact that past increases in interest rates limited the pressure exerted by demand.

This outlook was supplanted by a double exogenous shock at the start of the year which led to a further rise in inflation in emerging countries and a further correction in the bond markets.

The Russian invasion of Ukraine at the end of February led to a sharp rise in the prices of food and energy products. At the same time, the imposition of lockdowns in China to contain outbreaks of Covid-19 led to further disruption of global supply chains which added to underlying inflationary pressures.

2022.07.29.EM inflation pick

Looking ahead, it seems unlikely that a resolution to the invasion of Ukraine will come soon. This means that geopolitical risks emanating from Russia will continue to weigh on the outlook for commodity prices for some time to come.

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Energy markets are particularly vulnerable to fears that Russia will cut gas supplies to Europe. At the same time, the disruption of fertilizer supplies threatens the prices of agricultural products, in parallel with climate change and the nationwide embargo on exports of certain foodstuffs.

Beyond these particular risks, the macroeconomic drivers of commodities are deteriorating. Activity indicators are softening and the risk of a global recession is increasing (see Are we heading for a global recession?). This has started to put downward pressure on prices for many commodities in recent weeks and the possibility of demand destruction suggests further downside is looming.

At the very least, barring much stronger stimulus measures in China, it seems unlikely that demand-side pressures will drive commodity prices up significantly.

This means that the rise in food and energy prices in emerging countries should slow in the coming months. Admittedly, the use of futures prices in inflation estimates has been doomed to failure over the past two years. The backwardness of futures prices has been consistently misleading and is one of the reasons many economists have gotten the inflation outlook wrong.

Strongly positive real interest rates are needed

However, the current expectation of lower commodity prices is at least in line with the deteriorating growth outlook, which means that inflationary pressures should ease. In fact, as shown by the two graphs below, at first glance food and energy prices could fall by 6 and 20 percentage points (pp) respectively over the next 12 months. This would be enough to reduce average headline inflation in emerging countries by around 2.5 pp.

2022.07.29.Food and energy inflation

Core inflation in emerging countries should benefit from easing shortages of goods in the coming months. Global Purchasing Managers’ Indexes (PMIs) show delivery times from suppliers are improving as inventories are replenished, while port activity in China appears to be normalizing. A more general rotation of global demand in favor of services should also help dampen the rise in goods prices.

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However, underlying inflation in emerging countries has exceeded many indicators of price pressures. For example, core inflation is well above the rate implicit in producer prices, which themselves have exceeded corporate producer prices. And the relationship between underlying inflation and the evolution of exchange rates is totally broken.

This suggests that the disruptions in the goods sector were not the only driver of the acceleration in inflation and that the overheating of the economy has also pushed prices up in some cases. There are, of course, nuances at the country level, but in general this means that central banks in emerging markets need to raise their policy rates into positive territory to alleviate demand pressures.

2022.07.29.EM core inflation

If we compare inflation expectations for the coming year with market expectations for key rates in emerging countries, it is clear that central banks in Latin America are on the right track to achieve this. In fact, real rates in the region may start to look prohibitive as the economic outlook deteriorates, suggesting opportunities exist in these markets.

On the other hand, however, forward real policy rates look too low in parts of Eastern Europe and Asia, meaning that the relevant bond markets are likely to experience further repricing.

2022.07.29.Implied rate

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