Chile fires the starting gun on EM easing cycle

After raising interest rates aggressively during the post-Covid rebound, the trade-off between controlling inflation and supporting growth is tipping decisively towards easing in most parts of the emerging world.

The Central Bank of Chile’s (CBC’s) decision to lower rates by more than expected on Friday is likely to signal the start of a broad emerging market (EM) easing cycle, with Brazil set to follow suit this week. Rate cuts are likely to support EM financial markets, adding to recent gains in local currency bonds and brightening the outlook for growth-sensitive assets further ahead.

Steep falls in inflation opened the door to rate cuts

The decision by policymakers to cut rates by a consensus-busting 100bp to 10.25% on Friday made Chile the first major EM to lower its key policy rate since the aggressive post-pandemic tightening cycle across the emerging world. With the economy struggling, a marked improvement in the outlook for inflation encouraged policymakers to get on with the job of reversing past hikes that saw Chile’s policy rate climb from just 0.5% in mid-2021 to a peak of 11.25% in late-2022.

As we noted earlier this year, further steep declines in inflation, led by food, should make space for additional easing in the months ahead.

Charts: Chile likely to cut rates much further as inflation tumbles

Who’s next?

Attention now turns to which EM central banks are likely to be the next to start cutting rates. Prior to lowering rates on Friday, the CBC was one of a handful of EM central banks that had already been on pause for longer than usual. Others in that category include Brazil and the Czech Republic, where monetary policy announcements are due this week on Wednesday and Thursday respectively.

Chart: EM central banks are starting to get itchy feet

Like in Chile, the balance of risks in both economies has swung back from tackling inflation to supporting growth. This means that simple Taylor Rules (a monetary policy targeting rule) based on inflation and growth indicators are now consistent with lower interest rates.

It is highly likely that Brazil’s COPOM will lower the Selic rate from its current level of 13.75% on Wednesday after data released last week showed that inflation fell to just 3.2% y/y in the month to mid-July. A rate cut by the Czech National Bank on Thursday would be more of a surprise, but it surely won’t be long before easing commences.

Charts: The growth/inflation trade-off now decisively points to rate cuts

Further ahead, more EM central banks are likely to join the easing party as inflation concerns ease. In general, rates have the most room to fall across Latin America and Central and Eastern Europe. Rates have less room to fall in Asia due to the fact that tightening cycles there were much less aggressive.

Easing cycle to support EM markets

Markets already discount a decent amount of easing in most major EMs, and we are cognisant of emerging risks to the inflation outlook such as higher food prices as a result of El Niño. However, for the time being, the onset of the easing cycle is likely to support some further gains in local currency bonds at a time when currencies are benefitting from a hunt for yield and a sagging US-dollar. And with the lagged impact of rate cuts set to brighten the outlook for economic activity further ahead, growth-sensitive assets should also get some support.