Monetary and fiscal policy-makers in emerging markets are facing tougher challenges as we move into the second half of 2024. This year has brought some disconcerting election results and the discomfort is further sharpened by lingering broader geopolitical risks and the knowledge that the ‘easier’ miles of the disinflation marathon have largely been run.

The growth and resilience in emerging markets, despite restrictive monetary policy, has been helped by stronger US activity and a gradual recovery in Europe – both of which have helped offset a weaker Chinese economy. The policy easing delivered to date by many EM central banks, facilitated by lower inflation, has also helped the domestic growth story for many. However, our caution lies more with inflation than the activity outlook for EMs.

The sufficiently restrictive nominal rates territory that most central banks have delivered in the wake of the pandemic should – all else being equal – allow disinflation to continue (we remain generally below consensus on our 2024/25 consumer price index estimates). Even so, forecasts suggest most central banks will only get closer to desired targets in 2025, not hit them.

Inflation expectations have become more backwards-looking (sensitive to past inflation), but have also grown more reactive to surprises. With the last 12 months’ downside inflation surprises on our trackers having now turned neutral (Figure 1), the next leg of policy easing is likely to be slower and with more differentiation.

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Figure 1. EM inflation surprises have begun to turn neutral
Z-score

Sources: Bloomberg, Macrobond, BNP Paribas estimates

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This is already playing out in Latin America, for instance, in Brazil and Mexico, and we expect this to be followed by central banks in the central and eastern Europe region, such as in Czechia and Hungary. This is expected in the coming quarters given our view of gradually improving activity in Europe, still very tight labour markets, persistently stubborn wage growth and the cessation of energy subsidies in some countries.

Central banks in Asian EMs are also becoming increasingly sensitive to a ‘high-for-longer’ exogenous rates environment led by the US Federal Reserve – as evidenced by Indonesia’s decision to raise rates in May 2024, citing currency vulnerability concerns, and Thailand’s Monetary Policy Committee’s growing hesitance to bring cuts to the table.

Fiscal policy, meanwhile, has been on the backburner for most EMs. This could become more relevant in 2025 in the wake of several key elections in 2024 so far, with more to follow.

Most EMs are in better shape from the perspective of financial stability and vulnerability today compared with how they were ahead of the 2008 financial crisis, with lower external account imbalances, less hard currency debt exposure and more credible central banks. However, it does seem to us that a new political cycle is emerging. We have seen somewhat surprising election outcomes in South Africa (where the dramatic loss of the African National Congress majority is threatening less stable coalitions); in Mexico (where the Morena party secured a dominant position that may give it more clout to adopt left-leaning legislation and potentially problematic institutional reforms); and most recently in India (where a sharp drop in seats for the Bharatiya Janata party left it in need of support from an emboldened opposition).

This unsettled picture means the threat of populist policies needs to be closely watched, with risks now in play that could jeopardise the relatively well-behaved fiscal, and possibly monetary, policy behaviour that has helped the disinflation progress and underpinned resilient EM asset prices. Nervousness around Brazil and Colombia’s fiscal stances under their current administrations is already back on investor radars, contaminating inflation expectations and leading markets to price out room for additional rate cuts in these economies if they are to safeguard their currency performance.

Threats to global inflation stemming from looser fiscal policies and the possible imposition of additional hefty trade tariffs on China in the wake of US elections in November 2024, are also critical considerations for any EM policy-maker to navigate right now. One thing is certain, however. We can and we should expect more diversity in the reaction functions of EM central banks – the tricky trade-off between EM growth, inflation and foreign exchange stability looks set to become starker from here.