The great emerging market inflation of 2007 and 2008

In a recent FT oped on China, Ken Rogoff had a great one-liner:

"Those who think inflation is caused by too little pork rather than too much money are wrong."

Replace pork - culturally inappropriate for many high-inflation emerging market economies - with a more culturally neutral food, and his statement captures the core debate in a host of emerging economies right now.

The Gulf, Russia, Argentina, Hong Kong, China and no doubt others are trying to determine whether the recent rise in inflation reflects a rise in commodity prices (fuel, food) or inappropriately loose monetary policies. Stephen King of HSBS isn’t as pithy as Dr. Rogoff, but he framed the issue quite nicely last week:

Broadly, there are two competing explanations for the rise in emerging market inflation. The first is what I’d call the "bad luck" explanation. Those living in emerging markets have, on average, lower per capita incomes than those who live in the developed world. Proportionately, more of their income is spent on basic items such as fuel and food. The prices of these "basics" tend to move around in volatile fashion in response to bad harvests, occasional wars or the onset of disease. As a result, inflation rates within emerging economies move up and down a lot more than their equivalents in the developed world. High inflation in one year could easily be followed by low inflation the next year.

The second explanation is monetary in nature. Inflation is rising because monetary conditions are simply too loose. And because people in emerging markets spend most of their income on the basics, it’s no great surprise that the prices of fuel, food and other essentials go up. This is not a case of bad luck. It is, instead, the outcome (perhaps unintended) of a series of earlier monetary policy decisions

Most of the high inflation emerging economies either peg to the dollar or intervene heavily to manage their exchange rate against the dollar.

Ben Bernanke though can not really be blamed the rise in inflation these economies. 

No one forced the Saudis - just to pick an example -- to peg to a depreciating dollar and cut domestic rates even as domestic Saudi inflation rose. The Saudis could have dropped their dollar peg. Bernanke’s mandate is to pursue policies that support price stability and employment in the US - not to balance the monetary policy the US needs with the monetary policy the rest of the dollar zone needs. 

Right now Bernanke has his hands full with the US.   Moreover, it is almost certainly the case that the monetary policy the US needs is quite different from the monetary policy the rest of the dollar zone needs.  The Gulf clearly has decoupled from the US, and up until nowl, so has China.

As a result, China and the Gulf are importing a very expansionary US monetary policy at a time when their economies are growing rapidly and inflation rates are picking up.

Stephen King (HSBC) notes that inflation is the almost certain outcome in countries that peg to the dollar during a phase of catch-up and rapid productivity growth. Their real exchange rate needs to rise. If the exchange rate cannot appreciate, then inflation will shoot up.

What, though, if the authorities prevent the nominal exchange rate from rising? In these circumstances, the only other option, ultimately, is a rise in the so-called real exchange rate via a higher domestic inflation rate relative to inflation rates in other countries. Suppose, for example, that Chinese domestic prices and wages are rising 10 per cent per year whereas British prices and wages are rising at around 4 per cent per year. Under these circumstances, the Chinese worker’s buying power over the rest of the world’s output will be improving over time relative to the British worker’s (through Chinese eyes, British goods will appear cheaper and cheaper).

The US slowdown and associated series of rate cuts have just made the cost of dollar pegs a lot more visible now. And - as King notes - inflation tends to generate a lot of social and political strain.

rising inflation can easily lead to an unfair redistribution of income. Some will end up a lot better off. Others will be a lot worse off. The social tensions associated with this process can easily lead to political turmoil. Inevitably, politicians try to keep the lid on this pressure cooker by imposing price and wage controls, but then, of course, they’re heading straight back to the 1970s.

Even more developed parts of the dollar zone are felling to the strain.William Pesek doesn’t think a dollar peg still makes sense for Hong Kong. I agree.

Cutting rates in the face of rising inflation and rising home prices only fuels the current boom.

That is why I would add another risk to King’s list. A host of emerging economies are in effect adopting highly pro-cyclical policies right now.

In the Gulf, loose fiscal policy - spurred by strong commodity prices - has been combined with loose monetary policy and a weak exchange rate. All push the boom on. Tourism and property development are booming along with the petroleum sector. And rising inflation also creates pressure to loosen fiscal policy (why should living standard be falling when oil is high?) which only adds to inflationary pressures and pushes real rates down further. January inflation was up in Saudi Arabia. SAMA cut rates. Real rates moved into even more negative territory.

The Saudis have kept lending rates higher than deposit rates. But with inflation at 7% now and in my view set to rise toward 10% over the course of the year, the expected real lending rate is still quite negative.   The underlying pace of growth in the money supply, even with Chinese style rising reserve requirements, remains quite fast.

And in China low - or negative - real interest rates (See Justin Lin) have fueled an investment boom and contributed to the enormous (though now stalled) run up in Chinese stock market prices, along with higher real estate prices. The rise in the stock market could in turn help support consumption (the classic wealth effect). And all this has happened even as an undervalued real exchange rate, especially an undervalued exchange rate relative to Europe, has supported the export sector. The boom in exports and investment has been highly correlated.

The risk of course is the pro-cyclical policies on the upside will be replaced by pro-cyclical policies on the downside, and the excesses of the boom will deepen the bust.

So in some deep sense, the question is whether the great emerging market inflation of 07 and 08 will be followed by a big emerging market bust in 09 or 10, a bust that will have its roots not in a collapse in external capital inflows but rather in the domestic excesses in the boom years?