The Federal Reserve (Fed)’s rate cuts and a soft landing in the US should encourage more EMs to join the ongoing easing cycle over the coming year, and a step-change in Chinese stimulus is a potential upside to the EM activity outlook.

In September, the Fed started its easing cycle with a bang, cutting the funds rate 50 basis points (bps), which is what we expect to begin a gradual easing cycle. Indeed, eight major EM central banks also cut rates in September, reflecting an expansion of the easing cycle across regions (Chart 1).

Indonesia and South Africa delivered their first cuts of the cycle, while Czechia, Mexico, and Peru all cut for the second consecutive month. Chile, China, and Hungary also eased policy. With Asian central banks delivering cuts, an emerging market easing cycle is underway.

While markets have pared back expectations for a more aggressive Fed easing path in October, our base case for a gradual return to neutral remains favorable to EMs.

Volatility in market expectations for the Fed path may cause caution among central banks particularly sensitive to rate differentials: Bank Indonesia paused at its October policy meeting, but others press ahead with easing.

Indeed, central banks in South Korea and Thailand – both lower-yielding markets – began their cutting cycles in October. This highlights the growing shift towards neutral policy stances among policymakers, with the Reserve Bank of India also verbally shifting to neutral (we expect a rate cut before year-end). However, the ongoing conflict between Ukraine and Russia and the one in the Middle East poses risks to regional stability and global food and energy prices. This and the uncertainty around the US election outcome represent challenges for the EM outlook and will keep policymakers and investors cautious in the near term.

The EM easing cycle is likely to slow through 2025 as more central banks return policy rates to neutral or accommodative territory. We expect the Fed to cut 125 bps through 2025, moving policy towards neutral, and this will ultimately cap the extent to which some central banks can lower rates.

Inflation is increasingly well-behaved …

Policymakers have been able to loosen monetary conditions because inflation has fallen within target ranges in a growing number of EMs. Indeed, many began easing before the Fed, while others will opportunistically follow it.

Regional averages show headline inflation is now back around pre-pandemic rates (Chart 2), and high-frequency core measures signal a significant moderation of underlying inflationary pressures across the vast majority of EMs.

… But challenges lie ahead

The story is not uniform, and some EMs still face sticky inflation dynamics. Hungary and Poland stand out, with resurgent high-frequency core measures. Brazil also faces a challenging last mile of disinflation, which has forced the central bank (BCB) to make a U-turn and hike rates.

Hungary’s core inflation is partly a reflection of processed food pressures, and several of the spikes in inflation in some other countries can be attributed to electricity tariff hikes or removals of fuel and utility subsidies. However, there is enough lingering inflationary pressure in Hungary, Poland, and much of Latin America (LatAm) to motivate policymakers to move cautiously. Indeed, service inflation is proving more challenging for EMs to curtail (Chart 3). This may ultimately mean these central banks must keep policy conditions restrictive longer.

Inflation dynamics and fiscal policy risks

The key question heading into 2025 is whether further convergence with targets will occur and whether services inflation will dissipate. There are risks of supply-side shocks, particularly to food and energy, and more stimulatory fiscal policies, both domestically and externally, specifically in the US, which could push up inflation.

Food and energy inflation has eased substantially since early 2023, but disinflationary base effects will likely fade over the coming months. La Niña weather conditions and the Ukraine-Russia conflict threaten global food supplies. Concurrently, the conflict in the Middle East poses a threat to global energy prices and shipping routes.

Even in our base case, where a full-scale war between Israel and Iran is avoided, we see the possibility of oil prices spiking as high as $100 a barrel during bouts of volatility. This could temporarily add 0.5 ppt to headline inflation for some EMs. Exporters such as Brazil and Colombia would benefit from higher prices.

There is a risk that politicians could try to offset supply-side shocks on households via additional fiscal support. Fiscal policy has been a key area of concern for investors in Brazil. The slow progress in fiscal consolidation has helped to boost domestic growth, which could be why Brazil’s inflation is taking longer to recede. Indeed, rising inflation expectations linked to concerns around the fiscal path have forced the Brazilian central bank into a policy pivot – having begun the year easing, a hiking cycle began in September.

Other markets face similar fiscal concerns. Poland’s central bank paused its easing cycle over fiscal slippage concerns. Mexico's easing cycle could also end abruptly if fiscal policy, among other factors, such as minimum wage increases, proves inflationary.

Inflation readings have at least broadly surprised to the downside throughout 2024. However, with these potential supply shocks, EMs where inflation is at the upper bound of the central bank’s target range may judge that a more gradual monetary easing path is appropriate.

In contrast, countries where inflation is undershooting target or with very subdued core inflation have more scope to cut through this uncertainty. Much of Asia, Peru, Czechia, and South Africa are well placed to ease.

Economic growth seems set to slow

Growth appears to be softening but not dramatically (Chart 4). Indeed, real GDP growth in Q2 was still running at 4.3% annualized, above our potential growth estimate of 3.5% for the economies included in our EM ex-China Index.

Since late July, EMs’ macroeconomic data have largely fallen short of consensus expectations, potentially signaling that aggregate growth has fallen below trend. Despite some signs of an upturn in the year's first half, the manufacturing cycle appears to be turning through Q3. Global new manufacturing export orders have been cooling alongside output, weighing on the EM manufacturing index.

One area of strength continues to be the semiconductor cycle. Taiwan’s exports have bucked the trend thanks to still strong semiconductor demand from AI-related investment. Markets such as Malaysia, South Korea, and China should also benefit from the strong demand for semiconductors.

While tech could defy gravity for a while longer, global goods demand is likely to slow further, given our expectation that the US economy will cool. The US has been a major driver of global goods demand recently (Chart 5), and while we are not expecting a sharp drop in US demand, this is another reason to expect global trade to soften into 2025.

Weakness in recent Purchasing Managers’ Index (PMI) is not confined to manufacturing. Services have also decreased notably, pushing the EM Composite PMI to its lowest level since October 2023 (Chart 6).

Services activity has been driving EM growth, as tight labor markets, recovering tourism sectors, and strong external demand have all proved supportive. However, a turn in services activity could see EM growth fall below trend, potentially creating the output gaps needed to crack the last mile of inflation. Indeed, this could determine how much the rise in input costs is translated into output prices (Chart 7).

Chinese stimulus is no GFC repeat …

While the US economic path is a key factor in the outlook for EMs, China’s economic direction will also play a major role.

Chinese policymakers have initiated a coordinated policy pivot, promising to stabilize the property sector, deal with local debt problems, and boost domestic demand.

The extent to which stimulus will generate positive spillovers for other EMs is very uncertain. The size and composition of the fiscal package, which will be key to determining import intensity, remain undisclosed. And the extent to which the authorities are really planning on boosting household consumption also remains unclear.

… But should help trading partners and reduce disinflationary impulse

China’s investment and supply-side biased growth model continues to exert downward pressure on other countries. The export price deflator continued to trend down in September and is now 15% lower than its peak 18 months ago.

This may be helpful for some countries still battling inflation but also threatens the competitiveness of goods produced in other markets, adding to the headwinds faced by manufacturing sectors elsewhere. If household confidence returns and consumption picks up in China, it would go some way toward reducing trade tensions. Still, it is unclear whether markets are over-reading the Chinese Communist Party’s intent.

Political risks are at the forefront

Potential tailwinds from Chinese stimulus or the Fed easing cycle will come with the turbulence of the US election next month. Whoever sits in the White House will have a key influence on global growth, trade, and geopolitics. Policymakers are likely considering this uncertainty, and while it has yet to be a barrier to central banks delivering rate cuts, it may become increasingly part of the policy decision.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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