Sunday, December 12, 2010
Pumping up inflation in emerging economies
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular Sunday Times piece is available on www.thesundaytimes.co.uk, and now on the new Ipad app. This is an excerpt.

Britain is caught between two powerful forces when it comes to inflation. In most advanced economies there is a bigger worry about deflation than inflation. Inflation rates are typically 1% or so, and lower on a core basis excluding volatile items. America’s core inflation of 0.6% in October was the lowest for 50 years.

In America, the eurozone and Japan, inflation is the least of the worries. Last week’s sharp rise in government bond yields had nothing to do with inflation concerns and everything to do with fiscal fears, particularly the worry that the Obama administration will never get to grips with America’s budget deficit.

Poor Ireland’s debt troubles are made worse by the fact that it is in the grip of deflation. On the same basis that Britain has inflation of 3.2%, Ireland has deflation - prices are lower than a year ago - of 0.8%.

In many emerging economies, in contrast, the problem is inflation rather than deflation. Chinese inflation, 5.1%, is at its highest for more than two years. India’s wholesale price inflation is running at nearly 9%, as is the country’s food inflation. Argentina, though its figures are dodgy, is seeing inflation running up towards 30%.

Here in Britain, the inflation problem will get worse before it gets better. Petrol prices have been going up in the past few days, even before the January excise duty and Vat hikes. That Vat hike will affect a range of prices, even if retailers try to cushion the blow. The fact Vat also went up last January, when the rate was restored to 17.5%, means the impact next month on inflation will not be as bad as it might have been.

Even so, the Bank will have to make sure King’s inkwell is filled. After peaking at a little over 3.5% in the first quarter, it expects inflation to stay above 3% through 2011, before then falling.

The interesting question is how long the Bank will be able to keep interest rates at 0.5%, which it did again on Thursday, if the inflation overshoot turns out to be more enduring than it currently expects. It has already stretched the timetable for the return to the 2% target on several occasions.

It is not hard to explain why emerging economies have an inflation problem while most advanced economies do not. Commodity prices have risen 30% since the summer. The lower a country’s per capita gross domestic product (GDP), the bigger the share of incomes spent on food and other staples. Food prices are important in Britain, particularly for those on lower incomes, but their weight in the consumer prices index is less than 11%.

Should we be more worried about inflation or deflation? An interesting research note from economists at HSBC, led by Stephen King, nicely links deflation worries in the advanced economies to inflation in the emerging world.

The first part of the link is familiar. As HSBC’s King puts it: “In their desperation to kick-start growth and avoid the perils of Japan-style deflation, central banks in the Western world have opened up their monetary laboratories to find a cure.”

Though we cannot know for sure, that cure appears to have been partially successful. It has helped avoid a second Great Depression and, while some countries have fallen into the deflationary trap most, just, have so far avoided it.

Unfortunately, a bigger effect of all this monetary largesse appears to have been on the emerging world, and on commodity prices. “As the effects of QE have leaked out into the emerging world, the effect has become more and more visible.”

Before the crisis, people used to worry about the so-called yen carry trade; borrowing at near-zero interest rates in Japan and reinvesting in Britain, America or other countries where returns were higher.

Now there is, in effect, a global carry trade from all the advanced economies to the rest of the world. Investors can borrow at near-zero rates in America, Britain, the eurozone and Japan and re-invest elsewhere. In case of doubt, central banks are pumping money in to allow them to do so.

That is why emerging economies, led by China but including Brazil, South Korea and Hong Kong, have protested about the Federal Reserve’s latest round of quantitative easing (QE II). America, they say, is trying to solve its problems by creating inflationary bubbles in their countries.

It is also why, according to the HSBC analysis, the entire exercise may turn out to be counterproductive. Not only is much of this easing leaking out, but it is also creating a dangerous feedback for advanced economies themselves. Even though their sensitivity to higher food and commodity prices is less, the effect will nevertheless be to squeeze real incomes in the West, holding back the recovery in spending needed to get out of the economic morass.

What is the answer? One would be if, contrary to the conventional Washington wisdom of the past three decades, emerging economies were encouraged to reimpose capital controls. That would ensure that policy aimed at the West stayed in the West. Some countries such as Brazil and Thailand have already done this.

The other is that advanced economy central banks adopt what you might call the Doris Day approach, in other words Que Sera Sera, whatever will be, will be.

Western economies have to adjust after the crisis. Part of that adjustment involves slower growth than before. Trying to avoid it through super-expansionary monetary policy will not work. It is why I am against further expanding quantitative easing in Britain, and why the launch of QE II in America made me very uneasy. Sometimes you have to accept things have changed.