Emerging market (EM) monetary policy settings appear to be on the loose side from the perspective of domestic economic conditions and could tighten by more than the consensus expects as global monetary conditions normalise, according to the latest research from Fitch’s economics team.
Fitch has looked at the monetary policy stance of the 10 large EMs (the “EM10”) covered in its quarterly Global Economic Outlook through the lens of ‘policy rules’ that attempt to describe, in a very simplistic fashion, how central banks set interest rates in response to domestic economic conditions, namely inflation relative to target and the level of unemployment.
With nine of the EM10 having now formally adopted inflation targeting, it has been possible to model EM interest rate decisions using a rules-based framework typically applied to advanced economies. Fitch’s analysis shows that six of the EM10 are currently running policies that are looser than would be implied by these simple policy rules: Turkey, China, Poland, Brazil, Indonesia and India. Among these, Turkey is found to have the most overly-accommodative stance using this policy rules-based analysis. Brazil also has an overly-loose policy according to this analysis, although our framework does not factor in the likelihood of a large output gap in Brazil following the recent deep recession there.
“While the overall low level of inflation in the EM10 can justify loose monetary policy on domestic grounds, our analysis suggests that monetary policy appears overly loose relative to this point in the cycle”, said Maxime Darmet, Associate Director, in Fitch’s Economics team.
Therefore, EM policy rates could see more upwards adjustment than currently expected by financial markets as global monetary conditions normalise. This could be exacerbated by any generalised appreciation in the US dollar and associated declines in EM capital inflows.
In its forecasts, and consistent with these conclusions, Fitch already expects more tightening within the next two years than the market view for most of the EM10. Full forecasts can be found in the March edition of our GEO.
“Despite the gradual pullback of loose monetary policy in the US, the average real interest rate in the EM10 has edged down further since end-2017”, added Brian Coulton, Chief Economist at Fitch.
Russia, Mexico and South Africa are running a tight monetary stance relative to their domestic cycle. But the reversal of capital flows and the rising US dollar, in part spurred by the gradual ending of easy money by the Federal Reserve, has deterred these three countries from easing their policies and to remain cautious.
Only Korea is found to have current interest rates broadly in line with what domestic economic conditions would warrant.