LONDON Working out whether central banks will deliver on publicly-stated mandates has become a lottery for investors, especially in emerging economies, as the global credit crisis grinds into its fifth year.
Effectively reversing a two-decade move among emerging central banks towards greater transparency, independence and inflation-targeting, the shift is raising volatility on emerging bond and currency markets and could ultimately reverse much-needed investment flows.
Poland's trend-breaking quarter point interest rate rise on Wednesday sets it apart from emerging market peers which appear to have backed away from their inflation-fighting mandates.
Despite above-target inflation, central banks from Brazil to Indonesia have in recent months either resorted to sharp rate cuts or are holding out against tightening policy.
Poland's step will highlight the divide between those banks that are willing to act on inflation and others perceived to have succumbed to government pressure over growth, says Benoit Anne, head of emerging markets strategy at Societe Generale.
"The concept of central bank independence in emerging markets has been trashed; there is no longer a guarantee that central banks will be as proactive as they used to be in the face of rising inflation," Anne said.
"But if you have a bank like Poland, that can distance itself from the global picture and say a rate rise is needed to deal with inflation, it does send a message to the market."
In today's shaky global economy, it is easy to see why emerging governments want lower interest rates and exchange rates -- especially when many developed central banks have effectively torn up the rule books with their money-printing operations.
The difference is inflation, which remains a far bigger foe for developing economies than for their richer peers.
That is why emerging central banks' backsliding on controlling prices is causing unease among investors who discern a steady rise in inflation expectations. That erosion of faith in policymakers' commitment can in turn trigger a spike in borrowing costs.
Fund flows are reflecting investors' unease. Allocations have declined every month since last November, according to a survey by JP Morgan. As a result 80 percent of the flows into emerging fixed income this year have gone to dollar-denominated debt which is less vulnerable to central bank policy mistakes.
"Indonesia, Mexico, Turkey, Brazil, some of the real heavyweights ... all of these countries are moving towards ever lower structural rates of interest," said Christopher Palmer, head of global emerging markets at Henderson.
"That's possibly had some implications for volatility because at a lower percentage yield, investors may be quicker to abandon this asset class," he told a Euromoney conference.
Indonesia held rates steady on Thursday. Despite inflation at seven-month highs and rising inflation expectations it is not expected to hike rates at all in 2012 from current record lows.
But investors have already been dumping the rupiah, which is at two-year lows. Their share of the local bond market is down to 29 percent from a high of 35 percent .
On the other end of the spectrum are Korea and Russia which have firmly resisted cutting interest rates.
"There are central banks that still have credibility and those that markets are telling you have less credibility than they used to," says Kieran Curtis, a fund manager at Aviva.
"I'd put Mexico and South Africa in the second camp and Indonesia too I consider is running overly loose policy. In Brazil I would say future policy credibility is at stake."
For graphic on inflation, please click: link.reuters.com/kej28s
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Even formerly hawkish central banks appear to be backing down. After a prolonged 2010-2011 rate rise campaign, India shocked markets in April with a half-point cut. Clearly a nod to slowing growth, it almost tipped the rupee to a record low.
But nowhere is the loss of policymaking independence more marked than in Brazil, investors say.
"Brazil's central bank was seen as the Bundesbank of emerging markets," said UBS strategist Manik Narain, referring to Germany's central bank which has become the byword for policymaking discipline. "But since (president Dilma) Rousseff came in, it has clearly become hostage to policymakers' views."
An aggressive rate cut campaign that started in August has slashed the benchmark Selic rate by 350 basis points and is sure to be carried further as Rousseff has made cutting interest rates a top priority in order to revive growth.
While the real has slipped to three-year lows against the dollar, analysts at Barclays predicted the bond yield curve to steepen, noting the rising risk premiums at the long end. They also note that core inflation is running at almost 7 percent.
"Inflation doesn't respond immediately to interest rates but if inflation expectations become unhinged, Brazil could find itself in the position India is in today," Narain of UBS said.
Yet many argue the greater growth focus among emerging central banks should not be condemned in a world where central bank orthodoxy has largely been abandoned.
"It used to be a cardinal sin for central banks to fund their own governments but that's happening now in the name of quantitative easing or LTROs," says Philip Poole, head of global and macro strategy at HSBC Global Asset Management, referring to the European Central Bank's long-term loans to banks.
"So step back and think: have they lost credibility? I don't think so but their role has changed ... central banks do need to have a dual mandate: inflation and growth."
Back to Poland. Many reckon so great are the risks to the global economy that blind inflation targeting will backfire here as it did last year in the euro zone when the ECB was forced to cut rates a few months after it raised them.
"This may well be Poland's ECB moment," Capital Economics told clients in a note.
(Additional reporting by Clare Kane; Graphic by Scott Barber; Editing by Ruth Pitchford)