Inflation in Key Emerging Markets Is Now Lower Than in Developed Economies. Here’s Why.

Core inflation in emerging markets is bucking the historical trend, which has implications for investors in the region.

Emerging market (EM) inflation has historically exceeded that of developed market economies, but that relationship has begun to break down. We see several key reasons for the shift, which could have implications for investors in EM debt and other assets.

The historical tendency toward higher inflation in emerging markets comes down to a few key drivers. First are structural rigidities, arising in large part from inadequate infrastructure in EM economies, which contribute to high transaction costs and supply shortages. Inflation expectations also tend to be less anchored in EM; this is in turn a symptom of weaker macro policy frameworks, with fiscal expenditures causing growth to overheat and subsequently push consumer price index (CPI) inflation higher. In addition, exchange rates tend to be volatile and prone to weakness due to fragile external balances, which feeds into insufficient foreign exchange (FX) reserves. And lastly, the composition of emerging market CPI baskets gives a higher weight to more volatile items, such as food prices.

Chart 1

EM Consumer Price Inflation Has Historically Exceeded DM CPI, But That Trend Is Reversing

Source: International Monetary Fund (IMF) and Macrobond as of 31 October 2022. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The EM inflation evolution

Currently, looking at EM in aggregate, the historical trend still seems to be in place, if less dramatically so. But this hides a big change in the distribution of inflation across the EM universe. Only two regions are currently experiencing inflation well above that of the developed world: Eastern Europe and the Middle East (see chart 2). Average year-over-year CPI for the past three months is particularly high in Ukraine (24%), Turkey (80%), Argentina (78%), and Sri Lanka (65%).1 Ukraine’s high CPI is due to war-related supply shortages, while high levels for the others reflect macro policy mixes that have led to rapid weakening in exchange rates.

Chart 2

CPI Is Low in Asia and Appears to Have Peaked in Lat Am

Source: World Bank Group and Macrobond as of 31 October 2022. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

This is not the story for the rest of the EM universe, however. When excluding the above-named countries with especially persistent high inflation, which are not representative of the wider EM grouping due to idiosyncratic issues or market failures, EM inflation is now below that of its developed market (DM) counterparts, which have seen a sharp ramp-up in CPI. Inflation surprises have also been much more muted in emerging than developed markets of late (see chart 3).

Chart 3

Recent Inflation Surprises Have Been More Muted In EMs Than DMs

Source: Citi and Macrobond as of 31 October 2022. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

What caused the EM/DM inflation dynamic to flip?

We see a number of reasons why EM inflation is currently below that of developed markets. After strong expansionary fiscal policies in all regions in 2020, EMs embarked on a consolidation path in 2021, a year earlier than DMs, which helped temper demand-push inflation factors. EMs were also ahead of the curve with their monetary policy actions, hiking six to nine months before their DM counterparts. Additionally, EM exports have grown strongly in the past two years, bolstered by commodity prices, which have led to a current-account surplus for EM countries in aggregate – a big departure from the deficit recorded prior to 2020. This has made currencies less fragile and, in turn, led to relatively lower imported inflation. Food items carry a larger weight in EM CPI baskets (see chart 4), which has also benefited disinflationary trends. Food prices have fallen by 15% from their peak in March, and we forecast further deceleration into 2023.

Chart 4

Food Contributes More to CPI in Emerging Markets

Source: Organisation for Economic Cooperation and Development (OECD), Macrobond, and individual countries’ statistical agencies as of 30 June 2022. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

A disinflationary outlook for EM should persist for at least the next year

We expect further disinflation in EM over the next year and believe inflation will remain slightly lower than in developed markets over this period.

Chart 5

Policy Rates Will Likely Remain Positive for Most of EM

Source: Macrobond, PineBridge Investments calculations as of November 2022. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The disinflation we are forecasting differs across the EM spectrum, but we expect to see positive real policy rates for the majority of EM countries over the next 12 months (see chart 5). This should further strengthen exchange rates versus G10 currencies (excluding the US dollar), and for countries with high proportions of FX debt, it will help keep debt-to-GDP ratios contained. With EM central banks in a position to start cutting rates earlier, growth will be cushioned on the margin as well – a welcome development given the likelihood of slower global growth in 2023.

Overall, we believe current inflation trends put EM economic fundamentals on a more robust footing.