EM Rundown: Where is inflation hiding and what does it mean for a potential EM meltdown?

<p>When it comes to countries like the US and UK, policymakers are hyper-focused on inflation, waiting for any sign of rising price pressures to give […]</p>

When it comes to countries like the US and UK, policymakers are hyper-focused on inflation, waiting for any sign of rising price pressures to give them a green light to start raising interest rates. Not surprisingly, inflationary pressures remain minimal throughout most emerging markets, though there are some isolated countries where rising prices are a major threat.

For the most part, EM countries in eastern Europe and emerging Asia are seeing subdued inflation readings, stemming from their close economic ties to the nearby economic powerhouses (the Eurozone and China, respectively). As the impact of last year’s big drop in oil prices falls off the year-over-year comparisons, inflation in these regions is set to moderate and remain a low-priority issue for central bankers.

By contrast, inflation in a few select countries is poised to accelerate to potentially dangerous levels. Some of the regular weekly “punching bags” in this column include currencies like the Russian ruble, Turkish lira, South African rand, and Brazilian real, and as these currencies continue to struggle, inflation pressures will become more acute.

For instance, Russia’s most recent inflation rate was particularly elevated at 15.8%, and though the country’s central bank left interest rates unchanged at its 11% at its last meeting, it has already cut interest rates twice this year. If Russia’s central bank obstinately refuses to start raising interest rates to defend its currency, the current inflationary pressures could get out of control.

Inflation poses a smaller, but still significant risk in countries like Brazil (9.5% inflation), Turkey (7.1%), and South Africa (4.6%). The central banks of both Brazil and South Africa have already started to raise rates in response to the elevated inflation rates (and weak exchange rates), and it seems likely the Central Bank of the Republic Turkey (CBRT) will consider getting in on the tightening game after its elections in five weeks.

What traders need to watch, in these countries and elsewhere, is how traders react to the potential monetary tightening. If these currencies are unable to stem their recent declines, inflation could spiral out of control and increase the odds of a EM-driven panic spilling over to other emerging markets. The proverbial “canaries in the coal mine” to watch in the coming months will be Brazil, which was recently downgraded to a “junk” rating by S&P, and Russia.

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