Emerging Markets will be tested by inflation

Morgan Stanley economist Stephen Jen has said that it is the emerging market central banks, not the G-7 central banks who will be most tested by this bout of inflation that we are experiencing. His view of the implications of global inflation square well with Stephen Roach, Morgan Stanley’s head of Asia who recently said that Asia was the epicenter of the fight against inflation.

Note, many Asian central banks, like the U.S. Fed, have held interest rates below the rate of inflation. These negative real rates have led to overheating and cannot be sustained long-term. Eventually, interest rates in Asia must move higher. In the meantime, Asian producers are under pressure to pass through increased energy and wage costs or suffer margin erosion. The first signs of cost pass through are already evident in consumer goods from Asia.

See Stephen Jen’s research below or on Morgan Stanley’s website.

Some EM Central Banks to Be Stress-Tested by Inflation

Energy and food inflation has remained high. As the global economy has continued to exhibit signs of remarkable resilience, investors’ attention has, not surprisingly, shifted from ‘stag’ to ‘flation’. We are of the view that inflationary conditions will likely be negative for the currencies of many EM economies that are experiencing a negative terms-of-trade (ToT) shock. Stagflation would be even worse for these currencies. In contrast to developed markets, whose central banks could stay ahead of the inflation curve, we believe that developing market central banks will likely struggle to stay ahead of both the inflation and growth curves. The macroeconomic challenges to be faced by EM economies will be quite acute, and many EM currencies are likely to be penalised against the dollar.

Monetary Policy and Oil Price Shocks

Global energy and food price inflation poses a major challenge for monetary authorities around the world, with implications for currencies. Up to a certain threshold, say 6%, inflation should be positive for developed market currencies, in our view. Most central banks enjoy a meaningful enough amount of credibility that upside surprises to inflation should make investors look for eventual monetary tightening. The rule-of-thumb, thus, should be to buy the G10 currencies of countries that have upside surprises to inflation.

Having said this, it is important to appreciate the acute dilemma monetary policymakers are facing, and that, at some stage, if these types of global inflation persist and accelerate, central banks in developed economies may have rather diverse reactions and approaches, and the aforementioned simple rule-of-thumb would no longer be appropriate.

While much of the rise in oil and energy prices could be attributed to global demand for these products, from the perspectives of individual countries, oil and food price increases are supply shocks. Early work on the relationship on oil prices and developed market GDP suggests oil shocks were the dominant determinants of US recessions. For example, Professor James Hamilton (see Hamilton (1983) “Oil and the Macroeconomy since World War II”, Journal of Political Economy, vol. 91, (April), pp. 228-48) claimed that, since 1973, every upward spike in real oil prices has been followed by a surge in the US output gap. More specifically, Professor Hamilton demonstrated that an oil price shock had preceded (Granger-caused) all but one recession (in 1960) in the US since WWII.

Since shocks of this type are stagflationary, the Fed and other central banks are obliged to counter these inflationary pressures and not fully accommodate this shock. A reasonable approach for central banks would be to follow the Taylor Rule, i.e., adjust the FFR (Fed Funds rate) in response to changes in the deviations in core inflation and unemployment from their targeted levels (see Ed Gramlich (2004), Oil Shocks and Monetary Policy, Fed Speech, September 16). It is also important to keep in mind how high oil prices could reduce the potential world growth rate.). In an influential piece of research, Messrs Bernanke, Gertler and Watson (1997) (“Systematic Monetary Policy and the Effects of Oil Price Shocks”, Brookings Papers on Economic Activity 1: pp. 91-142) argued that, at most, only half of the observed GDP declines after oil price shocks could be attributed to the oil shocks themselves, with the other half of the recessionary pressures coming from the monetary reactions to the oil shocks. This exaggerated compression in output growth can be interpreted as a price to pay to secure stability in inflation expectations.

If, however, there is an underlying stagflationary trend coming from demographic pressures (aging and the shrinkage in the relative size of the work force in the U.S. and other developed nations) and globalisation, the stagflationary proposition confronting central bankers could be more acute than during the last great oil shock in the 1970s.

The bottom line here for developed economies is that oil shocks themselves are stagflationary and monetary reactions to these shocks have, during past episodes, exacerbated the declines in GDP growth, in exchange for more restrained inflation. Up to a certain point, inflation should lead to strong currencies as central banks tighten. But how developed market currencies perform as inflation rises will be a function of how stagflationary conditions get and how successful various central banks are seen at handling the stagflationary conditions.

Policy Dilemma Will Be More Challenging for EM

There are several reasons why central banks in EM will likely have much greater difficulties in the months ahead:

• Reason 1. Imported inflation cannot be offset. EM economies’ CPI baskets contain much higher weights for food and energy products than developed economies’ CPI baskets. This is important, because to offset inflationary pressures in these products – which are increasingly determined by international forces – EM central banks will need to somehow generate enough deflationary forces elsewhere in the economy. In other words, for EM central banks to achieve their targets on inflation, in the presence of high internationally determined energy and food inflation, they would need to be willing to drive the domestic economies into deep recession – a proposition that we believe is unlikely to be politically acceptable. The combined weights of energy and food products range between 30% and 70% for many EM economies, compared to around 25% for most developed economies. Further, actual food accounts for a bigger fraction of the retail costs of food items in EM economies, whereas in the developed world, the bulk of the retail cost of food items reflects retail, advertising and other service costs. In fact, it has been estimated that actual food accounts for some quarter to a third of the total cost of food products in the US. In any case, the point here is that fluctuations in international food commodities tend to feed into EM economies’ CPI far more easily than in the developed world, and such an impact tends to be so powerful that offsetting it would imply extreme measures by central banks. This cannot be positive for EM currencies.

• Reason 2. Rollin
g back of energy and food subsidies to keep stagflationary pressure sustained. We have pointed out previously (Enjoy the Energy Subsidies While You Can, May 22, 2008) that half of the world’s population now enjoys energy subsidies and about a quarter of the world’s gasoline is subsidised. Our analysis in that note was limited to the gasoline market, but the same logic applies to other energy products and food items. Subsidies mute the impact of high prices on the quantity of demand (i.e., prevent the demand curve from being downward-sloping). With subsidies, global demand for food and energy is not ‘destroyed’. But as food and energy prices stay high and rise further, EM economies will be under pressure to roll back these subsidies. The end result is that stagflationary conditions will persist longer in EM with subsidies than elsewhere. Often governments are forced to roll back on the subsidies and, by construction, the timing of the withdrawal of these subsidies is likely to be bad, both from a macroeconomic and social perspective. This cannot be positive for EM currencies.

• Reason 3. Inflation-targeting (IT) in general will be seriously stress-tested. The world’s headline inflation has trended lower over the past decades. Between 1997 and 2007, OECD headline inflation declined from 4.8% to 1.9%; BRIC headline inflation fell from 9.2% to 4.1%. (During this period, core inflation also fell, from 4.4% to 2.1% for the OECD countries, and from 4.4% to 1.3% for the BRIC economies.)

While better, more disciplined monetary policies have likely played an important role behind this trend, other factors (such as globalisation, deregulation and luck (this includes the lack of major global military conflicts and absence of other major shocks)) have arguably been at least as important. In this ‘Goldilocksy’ environment of the past, it was relatively easy for IT regimes to look good. But if the structural trend in global inflation is indeed turning, then IT regimes could be stress-tested. In fact, rigid forms of monetary policy will be stress-tested if the natural rates of unemployment and corresponding inflation rates are shifting. Further, if indeed this worry about more rigid forms of monetary policy is justified, then it is reasonable to expect these stress-tests to be more extreme for EM economies than for developed economies, due to Reason 1 mentioned above. We believe that the likes of Korea, Thailand, South Africa, Russia and Turkey will need to consider the following options: raise the numerical targets on inflation, have a moratorium on applying their inflation targets, change the targeted inflation indices (from headline to core), or abandon IT altogether. None of the above will be supportive of their currencies, in our opinion.

Bottom Line

Inflationary pressures of the type we are dealing with (triggered by energy and food price shocks) will pose a considerable challenge to monetary authorities, particularly those in EM economies. We believe that this is a powerful theme, which will hurt many EM currencies.