Inflation: An Old Enemy Back Again

The World Economy: Inflation's Back
Double-Digit Price Rises Are About To Afflict Two-Thirds Of The World's Population

From The Economist Print Edition | 22 May 2008

Ronald Reagan once described inflation as being "as violent as a mugger, as frightening as an armed robber and as deadly as a hit-man". Until recently, central bankers thought that this thug had been locked up for life. Thanks to sound monetary policies, inflation worldwide had stayed low in recent years. But the mugger is back on the prowl. Even though America is close to recession and growth in other developed economies has slowed, inflation is rising. Jean-Claude Trichet, president of the European Central Bank, this week gave warning about the mistakes of the 1970s, when inflation was let loose at huge cost to growth.

His words were aimed at rich-country central banks, but policymakers in emerging economies are the ones who should most take heed. In countries such as China, India, Indonesia and Saudi Arabia even the often dodgy official statistics show prices have risen by 8-10% over the past year; in Russia the rate is over 14%; in Argentina the true figure is 23% and in Venezuela it is 29%. If you measure the numbers correctly, two-thirds of the world's population will probably suffer double-digit rates of inflation this summer (see article).

A 1970s reunion you really don't want to attend

Taken as a whole (and using official figures), the average world inflation rate has risen to 5.5%, its highest since 1999. The main cause has been the surge in the prices of food and oil, which briefly soared above $135 a barrel this week. But Mr Trichet's concern is that higher headline rates could push up inflation expectations, leading to bigger pay demands, and so trigger a wage-price spiral, as in the 1970s. Central bankers' mistake then was to hold monetary policy too loose, so that higher oil prices quickly fed into other prices. So it is worrying that global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative.

By slashing interest rates as inflation has climbed, has the Fed sowed the seeds of a new inflationary era? That case looks hard to prove in the rich world. Inflation rates of 3.9% in America and 3.3% in the euro area are far higher than central banks want, and inflation expectations are rising. If growth in the euro area remains robust, the ECB should certainly worry more about inflation. Yet so far there is little sign that higher food and oil prices are pushing up other prices in the rich economies.

Wages have remained relatively subdued and core rates of inflation (excluding food and energy) are little higher than a year ago. Moreover, growth is expected to be below trend in America and Europe over the next year or so and unemployment is likely to climb, which will help to curb wage rises. America's consumer-confidence index has fallen to a 28-year low, which suggests that consumer spending will fall. This, in turn, will spur firms to cut costs and limit pay rises.

The picture is very different in emerging countries. Prices are rising much faster partly because food accounts for a bigger chunk of their consumer-price indices. But wages (rising at nearly 30% a year in Russia) and core-inflation rates are also accelerating. Many of these economies are operating close to full capacity, where inflation is more likely to take hold.

There are alarming similarities between emerging economies today and the rich world in the 1970s when the Great Inflation lifted off. Many policymakers in emerging markets view the rise in inflation as a short-term supply shock and so see little need to raise interest rates. Instead they are using price controls and subsidies to cap prices. Money supplies are growing almost three times as fast as in the developed world. Many central banks are still not fully independent. And inflationary expectations are not properly anchored, increasing the risk of a wage-price spiral. Emerging markets may as well be inviting the muggers into their own homes.

Watch your back

Rising inflation, like so much of the world economy in recent years, can be explained partly by the increasingly complex links between developed and emerging economies. Emerging economies shared some responsibility for America's housing and credit bubble. As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising. This pushed down bond yields. At the same time, cheap imports from China and elsewhere helped central banks in rich economies hold down inflation while keeping short-term interest rates lower than in the past. Cheap money fuelled America's bubble.

Now that this bubble has burst, the cross-border monetary stimulus has changed direction. As the Fed has cut interest rates, emerging economies that link their currencies to the dollar have been forced to run a looser monetary policy, even though their economies are overheating. Emerging economies with currencies most closely aligned to the dollar, notably in Asia and the Gulf, have seen the biggest price rises. Countries, such as Mexico, that have more flexible exchange rates and are more committed to inflation targets have done better.

Even if the Fed's interest rate suits the American economy, global interest rates are too low. In turn, the unwarranted stimulus to demand in emerging economies is further pushing up commodity prices; so too is speculative buying by investors seeking higher returns than from bond yields, which are still being depressed by the emerging economies' build-up of reserves. This stokes inflationary pressures in America and Europe and makes life difficult for rich-country central banks.

Loose money in America and rigid exchange rates in emerging economies are a perilous mix. The longer emerging economies hold down their exchange rates, the greater the risk of rising global inflation. Admittedly, exchange-rate appreciation is not as simple a remedy for emerging economies as some claim: a rise in interest rates and the expectation of a further appreciation in the exchange rate could, perversely, exacerbate inflation by sucking in more capital; and setting the exchange rate free risks massive overvaluation. But with an economic serial killer on the loose, one way or another monetary policy will have to tighten and exchange rates rise.


Inflation In Emerging Economies: An Old Enemy Rears Its Head
Emerging Economies Risk Repeating The Same Mistakes That The Developed World Made In The Inflationary 1970s

From The Economist Print Edition | 22 May 2008

Even as America's economy teeters on the brink of recession and many European economies are slowing, central bankers in rich countries fear rising inflation. Yet the risks they face are smaller than those in emerging economies, where inflation has risen far more over the past year to its highest for nine years. There are also an alarming number of similarities between developing economies today and developed economies in the early 1970s, when the Great Inflation took off. Are the young upstarts heading for trouble?

China's official rate of consumer-price inflation is at a 12-year high of 8.5%, up from 3% a year ago (see chart 1). Russia's has leapt from 8% to over 14%. Most Gulf oil producers also have double-digit rates. India's wholesale-price inflation rate (the Reserve Bank's preferred measure) is 7.8%, a four-year high. Indonesian inflation, already 9%, is likely to reach 12% next month, when the government is expected to raise the price of subsidised fuel by 25-30%.

Inflation in Latin America remains low relative to its ignominious past. Even so, Brazil's rate has risen to 5% from less than 3% early last year. Chile's has leapt from 2.5% to 8.3%. Most alarming are Venezuela, where the rate is 29.3%, and Argentina. Officially, Argentina's inflation rate is 8.9%, but few economists believe the numbers. Morgan Stanley estimates that the true figure is 23%, up from 14.3% last year.

Indeed, official figures understate inflationary pressures in many emerging economies. Widespread government subsidies and price controls are one reason, and price indices are often skewed by a lack of data or government cheating. China's true inflation rate may be higher because the consumer-price index does not properly cover private services. Delays in data collection in India can mean big revisions to inflation: the final number for early March was almost two percentage points higher than the original. The latest wholesale-price inflation rate might therefore be pushed up to 9-10%. If measured correctly, five of the ten biggest emerging economies could have inflation rates of 10% or more by mid-summer. Two-thirds of the world's population may then be struggling with double-digit inflation.

The recent jump has been caused mainly by surging oil and food prices. For example, in China food prices have risen by 22% in the past year, whereas non-food prices have gone up by only 1.8%. Governments have responded with more price controls and export bans. India's government has suspended futures trading in several commodities, which it blames (wrongly) for high prices. In the short run such measures may help to cap inflation and avoid social unrest, but in the long run they do more harm than good. Preventing prices from rising reduces the incentive for farmers to increase supply and for consumers to curb demand, prolonging the very imbalance that has stoked prices.

Some central banks, including those in Brazil, Indonesia and Russia, have nudged up interest rates this year. But they have not kept pace with inflation, so real rates have fallen and are now negative in most countries, with a few exceptions such as Brazil, Mexico and South Korea. China's real lending rate is minus 1%. Russia's main policy rate of 6.5% is almost eight percentage points below its inflation rate.

Many policymakers in emerging economies argue that serious monetary tightening is not warranted: higher inflation, they say, is due solely to spikes in food and energy prices, caused by temporary supply shocks and speculation. Higher interest rates cannot call forth more pigs or grain. They expect inflation to ease later this year as higher prices prompt an increase in supply (food prices have started to edge down over the past month) and as sharp rises in commodity prices drop out of year-on-year comparisons.

Yes, food inflation is likely to slow later this year; but that does not mean rising headline inflation can be ignored. The synchronised jump in global food prices suggests that there is more to the story than disruptions to supply. Prices are also rising partly because loose monetary conditions in emerging economies have boosted domestic demand [[and encouraged cost free hoarding (using interest-free money) for those who have the space to do so: normxxx]]. These economies have accounted for over 90% of the increase in global consumption of oil and metals since 2002 and for 80% of the rise in demand for grain. This partly reflects long-term structural forces, but it is also the product of a money-fuelled cyclical boom. Peter Morgan, of HSBC, says that the initial shock to food prices may have come from the supply side, but the strength of income and money growth helps to validate higher prices. Were monetary conditions tighter, rises in food prices might be offset by declines elsewhere, keeping inflation under control.

Another reason why central banks cannot ignore agflation is that it can quickly spill over into other prices. Food accounts for 30-40% of the consumer-price index in most emerging economies, compared with only 15% in the G7 economies (see chart 2). So food prices weigh more heavily on inflation expectations and hence wage demands than in the rich world. Tighter monetary policy would help anchor expectations and stop higher commodity prices spreading into the wider economy.

Analysis by Goldman Sachs, for 1990-2007, confirms that in emerging markets, higher food prices did seem to push up other prices. In most developed economies the link from food to non-food inflation was statistically insignificant. Besides the larger share of food, this has two causes: central banks' credibility is weaker in most emerging economies, so that inflation expectations are less firmly anchored; and real wages tend to be less flexible. Both increase the risk of a price-wage spiral.

Philip Poole, also of HSBC, says that many emerging economies have run out of spare capacity because investment has not kept pace with economic growth. Hence firms are more likely to pass on cost increases. In both Brazil and India capacity utilisation is at record rates. Brazil's unemployment rate is at its lowest for almost 20 years. China, though, may still have some slack, thanks to strong investment.

The second-round effects of rising food prices are already visible in most economies. Andrew Cates, of UBS, calculates that in both Asia and Latin America the core rate of inflation (ie, excluding food and energy) has risen by one percentage point in the past year, to 3.4% and 6.2% respectively; in eastern Europe it has risen by three points, to 7.4%, largely because Russia is overheating. (In contrast, average core inflation in rich economies has barely budged.) Inflationary expectations are rising and workers clamouring for pay increases. In a survey of inflation expectations in Argentina, the average reply for the next 12 months was 36%. Russian wages are rising at an annual rate of almost 30%.

Turning Off The Tap

Some countries look more prone to rising inflation than others. From an analysis of wages, inflation expectations, demand and capacity pressures, and monetary growth, Mr Cates infers that Argentina, Brazil, India, Russia and the Middle East oil exporters face the biggest risks in the months ahead. Pressures seem less great in China, Mexico, South Korea and Turkey.

Clearly, monetary policy needs to be tightened. Instead, it has in effect been loosened: real interest rates are generally lower than they were a year ago. Short-term interest rates are also unusually low relative to nominal GDP growth (a crude gauge of where rates should be), which implies that monetary policy is very loose (see chart 3). The broad money supply has grown by an average of 20% over the past year in emerging economies, almost three times the pace in the developed world (see chart 4). Russia's money supply has swelled by fully 42%.

Add all this up, and emerging economies bear strong similarities to rich countries in the 1970s, when the Great Inflation took off. A synchronised boom in the world economy has caused commodity prices to surge. Governments have responded with subsidies and wage and price controls. Official statistics understate price pressures. Economies are running at full pelt. Money-supply growth is soaring. Inflation expectations are not anchored and labour markets are fairly rigid, increasing the risk of a spiral in wages and prices.

According to conventional wisdom, the monetary-policy mistakes that caused the Great Inflation are much less likely today because central banks are independent of politicians. But unlike the Federal Reserve and the European Central Bank (ECB), many central banks in emerging economies (notably China, India and Russia) are not fully independent. In another echo of the 1970s, they often face intense political pressure to hold rates low to boost growth and jobs.

Emerging economies are also in danger of repeating the blunder of central bankers in the rich world in the 1970s: they focus on core inflation as a reason for holding interest rates below the headline inflation rate. But negative real interest rates then further boost demand, while rising inflation expectations trigger bigger pay claims. Unless central banks tighten their grip soon, inflationary expectations could surge.

Central banks' monetary independence is also severely constrained by governments' desire to hold down currencies at a time when international capital is highly mobile— a problem the developed world did not face three decades ago. When central banks intervene in the foreign-exchange market to prevent a currency appreciating, they have to print money to buy dollars, which boosts domestic liquidity. The Fed's recent interest-rate cuts have made it even harder for emerging economies to tighten policy. If they raise rates they attract bigger capital inflows, and the extra intervention required to hold down their currency fuels inflation further, defeating the rate rise.

The central banks of both China and India have raised banks' reserve requirements several times this year to try to mop up excess liquidity, but they have left interest rates unchanged. The recent slide in the rupee leaves the Reserve Bank of India with more room to raise rates, but it has been slow to act. Hong Kong and the Gulf states, which still peg their currencies tightly to the dollar, have even been forced to cut interest rates, although their buoyant economies need tighter policy.

You might suppose that a downturn in America would tend to slow the emerging economies, but they have continued to sprint. Although emerging economies may have decoupled from America, their monetary policies have not. As a result, a slowing United States could perversely prove inflationary for them. The more the Fed cuts, the stronger the growth in liquidity and domestic demand in the developing world. In turn, this means higher commodity prices, which further squeeze American incomes and spending, prompting the Fed to push interest rates even lower. One way to regain control of interest rates is to impose tougher temporary restrictions on capital inflows. For example, in March Brazil introduced a 1.5% tax on foreign investment in government bonds. However, most studies suggest that capital controls do not work well in the long term.

To many Western economists and policymakers the solution is simple: emerging economies should allow more flexibility in their exchange rates. This would permit them to raise interest rates, and a stronger currency would help to curb import prices. But the links between exchange rates and inflation are complicated. Stephen Jen, of Morgan Stanley, argues that revaluation could encourage investors to expect further appreciation, which would attract yet more inflows of hot money and so exacerbate inflation. This is the problem that China now faces.

The only way to stem speculative inflows is to revalue a currency by so much that investors do not expect a further rise. But how much is that? Take the yuan. Mr Jen reckons it is already near "fair value" against the dollar, judged by such things as relative productivity growth and the terms of trade. On the other hand, to eliminate China's current-account surplus, the yuan might need to rise by a staggering (and politically unacceptable) 100%.

Mohsin Khan, the IMF's director for the Middle East and Central Asia, made a similar argument last week for the Gulf states. They should not revalue or modify their exchange-rate regimes now, he said, although inflation is high and rising. Any move too small to alter investors' expectations could draw in more short-term capital and add to inflationary pressures.

With capital so mobile and America's monetary policy so loose, emerging economies have no easy fix for inflation. Interest rates clearly need to be raised by a lot, but a tidal wave of capital could either boost domestic liquidity or cause currencies to become overvalued. Brazil has allowed its currency to rise by more than 100% against the dollar over the past five years. This has helped to bring inflation down (though it is now rising again), but the real is now widely thought to be overvalued, pushing the current account back into deficit.

The Only Way Is Up
One solution is to tighten fiscal policy, which would reduce excess demand. Rapid growth in public spending is partly to blame for the excessive growth in Brazil's domestic demand. But fiscal tightening would be hard to justify in China, which already has a budget surplus. A larger surplus would boost domestic saving and hence the country's already large current-account surplus. Either way, emerging economies need to accept that because their productivity growth is faster than the rich world's, their real exchange rates will have to rise over time.

That must mean either a rise in the nominal exchange rate or higher inflation; they cannot escape both. What does higher inflation in emerging economies mean for the rich world? Continued rapid growth in those economies means that the prices of food, energy and raw materials will remain high. In other words this is a permanent relative-price shock, not a temporary one. Yet this does not mean that commodity prices will keep rising at their current pace. Higher prices will encourage increased supply. And even if prices remain at today's levels, the 12-month rate of increase will decline, helping to ease global inflation.

There are also concerns, however, that after many years in which its exports have helped to hold down global prices, China is now exporting inflation in manufactured goods. Figures from America's Bureau of Labour Statistics show that after falling for several years, the prices of imports from China rose by 4.1% in the year to April, the largest 12-month increase since the series started in December 2004.

China's new export?

However, Jonathan Anderson, of UBS, reckons that the sudden spurt in the prices of Chinese goods is misleading. If you look instead at the dollar prices of Chinese re-exports from Hong Kong (a series with a much longer pedigree), mainland export prices have been rising by around 3% a year since 2004. And if export prices have picked up recently this is entirely because of the rise in the yuan against the dollar, not faster inflation in China.

In any case, the impact of China on global inflation depends on differences in price levels between countries, not on the rate of change in its export prices. China has helped to hold down inflation in developed economies because its goods are much cheaper and they are gaining market share, replacing more costly goods. This will remain true for many years. Competition from China also forces local producers to cut their prices and it curbs wage demands in rich countries. As China moves up the value chain it will pull down the prices of a wider range of products. In other words, China will continue to help hold down global prices— although possibly by less than in the past.

The biggest risk from rising inflation lies in emerging economies, not in the developed world. Because food has a much bigger weight in household spending, not only are those economies more prone to a surge in inflation now, but the social and political consequences would also be more severe. This week Jean-Claude Trichet, the ECB's president, warned central banks around the globe not to repeat the mistakes of the 1970s. Back then, emerging economies played a far smaller role in the world than they do now. To maintain their new-found strength, their policymakers need to keep a firm grip on inflation. The longer it is allowed to climb, the greater the danger to future economic growth.

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Normxxx    
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