New Europe’s central banks are caught between fighting inflation rock and growth-boosting rate cuts hard place

New Europe’s central banks are caught between fighting inflation rock and growth-boosting rate cuts hard place
Russia has kept interest rates higher than necessary while inflation has fallen to protect itself from US sanctions.
By Ben Aris in Berlin March 6, 2019

Emerging markets central banks switched from tightening into easing mode in February, taking their cue from a dovish turn at the US Federal Reserve and a dollar rally that has run out of steam, for now.

That will be good for growth. But it is also good for the political leadership that want to be seen as promoting prosperity in front of voters. The temptation is to lean on the local central bank governor to cut rates faster then they should. That's a problem for emerging market countries but much less for the more developed economies in the region. And central banks in 37 global developing economies produced three net rate cuts compared to one net rate hike in January, reports Reuters.

By end-January, interest rate raises by major emerging market central banks had outstripped or matched cuts for nine straight months - the longest such run since the summer of 2011 - as policymakers battled the fallout from a strong dollar, rising inflation and softer currencies that dominated most of 2018, reports Reuters.

Rates and growth

Emerging markets need to be tougher on inflation and hike rates more than developed market regulators, but the issue of central bank independence was highlighted by the Turkish currency meltdown last year.

As the Turkish lira went into free fall the Turkish central bank was unable to stem the bleeding with a rate hike thanks to Turkish President Recep Tayyip Erdogan's unorthodox ideas about the relationship between rates and inflation and his powerful role in the country.

“The lesson from Turkey over the last few years is that it takes time for political pressure on the central bank to have negative macroeconomic consequences. With this in mind, while recent developments in India are worrying, we are more concerned about the direction of policymaking in Romania,” William Jackson, chief emerging markets economist for Capital Economics, said in a note in January. Romania caught flak as the regulator was slow to raise rates when faced with an overheating economy in the last few years.

The problem is that the erosion of central bank independence leads to inflation expectations being “unanchored” as uncertainty over price stability itself causes inflation. That then leads through to wages and price setting behavior that cause actual inflation. That in turn causes the currency to sink as countries struggle to maintain their competitiveness and that depresses investment.

Letting inflation rise in an emerging market will very effectively kill off growth, but strictly targeting inflation in developed markets can actually hurt growth, according to a research paper by Behrooz Gharleghi of Dialogue of Civilizations Research Institute (DOC) entitled “Central bank independence and economic growth,” which sets the border between emerging and developed markets at a GDP per capita (adjusted for purchase price parity) of $9,800.

“If GDP per capita is higher than of ~$9,800, central bank independence has a negative impact on growth, whereas for poorer countries (with PPP GDP below $9,800) the impact of central bank independence on growth is positive,” Gharleghi found from studying the growth in 31 different countries.

Just why strictly limiting inflation in developed markets impedes growth is not entirely clear, but Gharleghi speculates that in emerging markets if the regulator is not independent enough then it can be forced to loosen monetary policy by politicians that leads to hyperinflation and crises. However, if the central bank in developed markets sticks too rigidly to fighting inflation it ignores the need for growth in an economy that can absorb the inflationary pressure more easily.

“Loose monetary policy in this case can alleviate the negative impact of price rigidities on growth by ensuring that actual output approaches potential output levels. If the central bank is too independent, it does not care about output and unemployment, but only about bringing down inflation and stabilising exchange rates, so there is a negative impact on growth,” concludes Gharleghi.

Ukraine and Russia are cases in point. Per capita GDP (PPP) in Ukraine was $2,640 in 2017 whereas it was $10,743 in Russia, putting the two countries on either side of the EM/DM border.

Since Ukraine’s economic meltdown in 2015 that saw the economy contract by a whopping 15% the country has been battling against high inflation – with some success.

Ukraine’s inflation soared to over 60% in the first quarter of 2015, which the National Bank of Ukraine (NBU) countered with rate hikes that took the policy rate to a growth-crushing 30%. The effect of the crisis was disastrous for economic growth, but within a year inflation had fallen to under 20% and the NBU was able to start cutting rates within a few months of the emergency hike in 2015.

Since then the NBU’s tight monetary policy has brought inflation under control, although the regulator had to hike rates three times in 2018 as inflation started to tick up again. Ukraine finished 2018 with inflation of 9.8% and a prime interest rate of a still very high 18%. But the outlook for this year is for inflation to fall into single digits, which would give the NBU room to make some growth-making rate cuts. Clearly in Ukraine’s case the tough and independent stance the NBU has taken on fighting inflation has stabilised the economy and laid the foundation for sustainable growth going forward.

Russia also had a crisis in 2015 trigged by the collapse of oil prices that lead to a halving of the value of the ruble. The Central Bank of Russia (CBR) also introduced a hefty rate hike to 17% as inflation soared to almost 17%.

However, Russia’s economy is much more robust and diversified. The economy contracted too, but by a modest 3.2% in the third quarter before growth went back into the black in 2016. With a shallower fall and lower inflation the CBR has been able to cut rates continuously in the subsequent years as inflation fell to a post-Soviet low of 2.2% at the start of 2018.

Going back to the difference between a developed market and an emerging one, clearly Russia’s 2.2% inflation in January 2018 is a “normal” market rate of inflation whereas Ukraine’s 14% for the same month is still an emerging market rate.

Both markets are experiencing lacklustre growth, but they are in very different positions when it comes to monetary policy interest rates. Ukraine is still facing very significant inflation pressures as it struggles to get back to its feet and the NBU has to stick to its tight monetary policy.

Like the NBU, the CBR also hiked rates twice at the end of 2018 as inflationary pressures reappeared, driving up consumer price inflation (CPI) to 4.3% at the end of the year. However, the CBR decision to hike rates in September 2018 was more to do with its sanctions war with the US than inflationary pressure. The new so-called Daskaa sanctions are expected in April that may destabilise the ruble and the CBR wanted to shore up the ruble ahead of time.

Russia’s economy ended 2018 with 2.3% growth after a controversial upgrade, but this is clearly way below potential – and the official forecast for this year is an even lower 1.3-1.8% growth, before it bounces back to 3% in 2021, after the Kremlin’s May Decrees investment programme starts to make itself felt. The CBR should cut rates but thanks to the sanctions regime it is running an extremely austere fiscal policy that is more about protecting Russia from economic attack than promoting growth and prosperity.