In 2022, central banks around the world marched to the same policy beat: watch inflation rising, raise interest rates, repeat. But this year, synchronized rate tightening has given way to a divergence in monetary policies. Here is a sample of recent decisions by central banks: the US Federal Reserve has held rates steady, the European Central Bank has hiked as predicted, Australia and Canada raised rates after a pause, Norway and the UK sprung unexpectedly sharp hikes, India paused, China and Vietnam started easing, and Japan continued its pre-covid easy policy. All this against a backdrop of still-simmering inflation and geopolitical tensions. Here are five takeaways on the implications of these diverging policy actions.
1. Prudence pays
Central banks that raised rates early and steeply—at the first signs of demand heating up—are now in a position to pause and wait for the rate hikes to work through the economy. Emerging markets in Latin America belong to this category. They were probably motivated by past episodes of hyperinflation. But central banks of advanced economies, led by the US and Europe, fell behind the curve, believing inflation to be transitory for a long time. They are still in the tightening mode.
Asian emerging economies fall somewhere in the middle. For instance, India started increasing rates only in May 2022 but the hikes were swift and aggressive. The Reserve Bank of India (RBI) remains cautious about future rate actions, given that the El Niño effect and geopolitical developments could easily push up prices again. Policy prudence and frontloading of rate hikes is critical for emerging markets because it creates confidence in their ability to manage inflation.
2. Initial conditions
A country’s unique initial conditions play a key role in determining the nature and effectiveness of monetary policy. Specifically, three factors seem to have made a difference. First, countries that started from near-zero interest rates needed significant hikes to ensure that policy was restrictive enough to dampen demand and inflation. That explains why the Fed rate exceeded its preferred inflation measure only in February 2023. On the other hand, India started tightening from a relatively high 4% rate, so the real repo rate (repo rate minus inflation) had already turned positive by November 2022.
Secondly, the US and advanced economies in Europe implemented large fiscal stimulus programs during the pandemic. This fuelled consumption demand by putting more spending money in the hands of households. These countries experienced inflation that raged for months despite rate hikes. Thirdly, country-specific factors such as post-Brexit supply shortages (the UK), economic crisis (Sri Lanka) or excessive dependence on Russian gas (Germany) also impacted inflation control.
3. Lessons learnt
In 2013, exchange rates of the Fragile Five—Brazil, India, Indonesia, South Africa and Turkey—plummeted on the announcement of a possible policy tightening in the US. Since that “taper tantrum”, these and other emerging economies have worked to reduce their external vulnerabilities. Current account balances have improved: Brazil runs a trade surplus due to soybean and oil exports, India has strong services exports, and Indonesia recently recorded a decadal-first current account surplus on the back of commodity exports.
Strong trade linkages with China have contributed significantly to emerging market growth. Also, sovereigns have reduced currency risk by issuing more domestic debt. In general, lessons from the taper tantrum have been well learnt, barring exceptions such as Turkey. As a result, most emerging markets fared much better in 2022, despite the sharp rate hikes. While their currencies depreciated, the economies were not pushed into an external crisis or economic instability.
4. Flexible targets
Advanced economies usually target low inflation rates: both the US and European Union target a 2% rate. Emerging economies generally set higher inflation targets. Currently, inflation in most advanced countries is fairly high, despite over a year of monetary tightening. This has led to discussion about resetting inflation targets upward. The advantage would be fewer rate hikes, which in turn would minimize the possibility of a growth slowdown.
In India, inflation was above the 4% official target through most of 2021-22. That was well before the Ukraine war or the rate hike cycle, but there was no RBI policy intervention. The lesson here appears to be that slightly higher inflation can be tolerated in the interest of growth, and rate increases are necessary only when inflation goes out of hand. A central bank can retain its credibility by balancing growth and inflation flexibly, rather than sticking to a rigid target.
5. Credible communication
A central bank that consistently forecasts inflation at 4% when it is actually around 8% won’t be trusted. So those that communicate clearly, honestly, and regularly are better at managing expectations. In emerging economies, political interference is also a concern. But central banks have performed well on this count.
Brazil has hiked its policy rate by a whopping 11.75 percentage points so far though 2022 was an election year. Mexico has withstood political pressure to cut rates. Even Turkey, whose president refused to raise rates initially, has finally come around to it. Some of this behaviour is attributable to market reaction, which is swift and ruthless when politics triumphs over economics. Consider Turkey’s recent action to hike rates: the currency fell in response because markets were not convinced that the tightening would continue. In other words, the rate action lacked credibility.
The author is an independent writer on economics and finance.