Are central banks in emerging economies losing their nerve?
Improved conditions bring varying approaches in Turkey, South Africa, India and Brazil
Central banks across a clutch of emerging markets are grappling with the dilemma of how best to conduct monetary policy when inflation remains high but growth is extremely weak.
The moment of truth for policymakers has arrived exactly a year after the United States Federal Reserve triggered a sharp sell-off in developing economies by signalling an end to its programme of quantitative easing - a crucial pillar of support for "risk assets".
It has also arrived just as some emerging market policymakers appear to be losing their nerve, particularly those who have recently begun the process of correcting the macroeconomic imbalances that rendered many developing economies vulnerable to the withdrawal of US monetary stimulus.
That market sentiment towards emerging market assets in general has improved significantly of late throws this dilemma into even sharper relief.
The more favourable market conditions over the past three months are encouraging some central banks to throw caution to the wind, while dissuading others from taking the necessary measures to suppress inflation for fear of crimping growth further.
Turkey's central bank, which damaged its inflation-fighting credentials on May 22 by cutting its benchmark interest rate by half a percentage point to 9.5 per cent despite a surge in inflation, is sliding down a slippery slope.
It was only four months ago that Turkey was forced to raise rates aggressively to shore up the country's wilting currency, the lira.
Although concerned about the political and economic sustainability of double-digit rates, markets greeted that move positively, taking it as a sign that Turkey's central bank was finally getting serious about reining in inflation and curbing the country's dangerously high current account deficit, which reached 8 per cent of gross domestic product last year.
Now it looks like the central bank is using the cover of favourable sentiment towards emerging markets to cut rates sooner than would otherwise be warranted by Turkey's inflation rate, which, at nearly 10 per cent, is double the central bank's target.
What is worse, Turkey's prime minister, Recep Tayyip Erdogan, is pressuring the central bank to cut rates more aggressively, threatening its independence and undermining the credibility of Turkish monetary policy further.
In South Africa, although inflation is lower, at 6.1 per cent, interest rates stand at just 5.5 per cent, leaving the country with negative real rates at a time when its currency, the rand, remains vulnerable because of the large current account deficit.
Markets are pricing in nearly 1.2 percentage points of rate increases in South Africa over the next year or so. Yet the central bank is reluctant to raise rates as the economy flirts with recession.
The longer South Africa puts off rate increases, the greater the risk that it will have to tighten policy much more sharply should sentiment towards it - and other emerging economies - deteriorate again.
Indian monetary policy, on the other hand, has become more credible, mainly because of the faith investors place in the governor of the central bank, Raghuram Rajan - a former chief economist at the International Monetary Fund. On June 3, the central bank left its benchmark rate at 8 per cent, having raised it by 0.75 percentage point since Rajan assumed the governorship in September.
Although inflation in India stands at 8.6 per cent, the highest rate in emerging Asia, markets appear confident that Rajan and Narendra Modi, India's new popular prime minister, will work together to curb inflation. It is the mirror opposite of Turkey's policy regime.
Right now, Modi and Rajan are the dream team of emerging market investors.
Yet the apparent harmony between the two dominant figures in India's political and economic life could easily give way to major disagreements.
While Rajan's overriding objective is to lower inflation, Modi's is to kick-start growth.
Indeed, the longer sentiment towards emerging markets remains favourable - last week was the ninth consecutive week of inflows into emerging market bond funds, with dollar-denominated debt flows back in positive territory - the more difficult it will be for central banks to maintain tight monetary policies.
Brazil's central bank, which decided on May 28 to keep its benchmark rate unchanged for the first time in more than a year after raising rates nine times to 11 per cent, appears to have reached the political and economic limits of double-digit rates.
With Brazil's economy barely growing in the first quarter and President Dilma Rousseff up for re-election in October, the lack of growth is now the No1 concern.
Yet inflation in Brazil, which has ticked up to 6.3 per cent, is expected to continue rising. Brazil's rate-raising cycle may not be over yet.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy