A Nuanced Inflation Shock to Emerging EconomiesJuly 14, 2008 By
Stephen Jen & Luca Bindelli |
London Summary and Conclusions
Contrary to popular presumption, EM economies have a legitimate choice to either fight to stay ahead of the curve on inflation or accommodate the inflation shock and protect growth. How the investment community reacts to different policy choices will be a function, among others, of its opinion of what EM economies should do. Our guess is that, given that most macro investors appear to have the view that ‘inflation is bad’, the currencies of countries that try to fight inflation may initially be rewarded while those of countries that accommodate inflation may be punished. However, the reaction of the equity markets may be exactly the opposite, that dovish policies that protect growth could be received more favourably.
EM Hit by Two Issues: Inflation and Oil
In our recent writings, we have focused on two related issues that are impinging on EM. Inflation is more of a cyclical issue that should fade over time (i.e., a couple of quarters to a couple of years, depending on the profile of commodity prices and global monetary policy reaction). The oil price rise, on the other hand, is likely to be secular, and will require structural changes in various heavy energy-consuming countries for this issue to be absorbed. The focus of this note is on the first – inflation – issue.
This is an issue because EM, for the first time in over a decade, is facing an upward drift in inflation. While much of this has so far been fuelled by internationally determined food and energy inflation, these items make up such large portions of the CPI baskets in EM that they will most likely have spillover effects on other products and services. EM inflation (proxied by the BRICs) has been steady declining since the mid-1990s, and only the Asian Currency Crisis temporarily disturbed this otherwise steady trend. Recently, however, headline inflation has accelerated, with core inflation starting to be dragged modestly higher.
Clearly, if commodity prices collapse now, inflation would not be much of a problem. And we are watchful of this scenario. In fact, some EM economies have the strategy of waiting for, and not acting on, this commodity inflation surge to reverse or to fall out of the inflation calculations. But if commodity prices continue to trend higher, what should these central banks do, and how will their financial assets react to inflation and the policy reactions? These questions are the focus of this note.
Widely Held Opinion on Inflation and Growth…
Our impression is that the Phillips Curve is the dominant framework most investors may have in mind when they think about the relationship between inflation and growth. This is why there is a presumption that there is a positive relationship between these two variables.
…but the Long-Term Relationship Is a Totally Different Story
The Philips Curve captures the short-run relationship between inflation and the output gap. But what may interest policy-makers in EM economies is the long-term relationship between inflation and growth. In other words, the policy question is not just whether there is a growth trade-off in stabilising inflation (which is the familiar dilemma confronted by most central banks), but also whether it makes sense for EM economies to try to keep inflation low. In our view, this distinction between the short-term and long-term aspects of how inflation affects economic growth will matter a great deal in the coming months, because we believe that the thought process of many EM policy-makers will be driven as much by these long-term considerations as it will by short-term issues.
Statistical Facts about Inflation and Growth
The relationship between inflation and the long-term economic growth rate is a (unsettled) five-decade-long debate in the economics profession, both in terms of theory and empirical work. Arguably the more intuitive side of the debate is that inflation is bad for growth. Most arguments supporting this view are based on how money as a medium of exchange is disrupted by uncertainties on future prices. Specifically, the level and volatility of inflation is disruptive for economic agents in the process of them paying for real goods and services. Real resources devoted to avoiding costs associated with settling these transactions with non-interest-bearing money balances are a welfare loss to the society. Keynes made this point in 1920: “As inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.” Inflation (a nominal factor) could thus have a negative impact on growth (a real factor).
On the other hand, it has been argued by James Tobin – a Nobel laureate – that inflation may, theoretically, be positive for growth, if monetary wealth is allocated to physical investment/capital. This line of argument is centred on the role of money as a store of value. Inflation and growth should thus be positively related both in the short run (Phillips Curve) and the long run.
In short, whether inflation is positive or negative for long-term economic growth depends on whether money is a substitute (a store of value) or a complement (a medium of exchange) for physical capital.
This theoretical debate can only be settled by statistics. Here are some key statistical facts about this relationship:
• No clear systematic relationship between inflation and long-term growth. Unlike the Phillips Curve relationship, and contrary to popular presumption, the long-term statistical relationship between inflation and growth has been rather unstable and inconsistent, over the past decades, and across countries. There were episodes of high inflation and high growth, as well as high inflation and low growth.
• High inflation (15-30%) was often accompanied by high economic growth. When inflation rates breach 40% or so, inflation is almost always bad for growth. However, inflation of around 15% has historically not been particularly problematic for economic growth. In the 1960s, Asia and Latin America experienced high growth-high inflation phases. Per capita income growth in these countries actually accelerated when inflation rose from single-digit to double-digit levels. Further, such a state had been sustained for a long time without major disruptions. Even now, China and India’s rapid economic growth rates are accompanied by rising and high inflation, with no apparent extreme tensions in the economies.
• Inflation reduction has output costs. Stabilisation of hyper-inflation has had no major output losses. But reducing inflation from ‘high’ to ‘moderate’ has led to costly output losses. The experience of the US under Fed Chairman Volker – with the US economy going through a recession and a period of high unemployment to bring down inflation – is particularly representative of this process.
What Does All This Mean to Investors
The above discussion and statistical regularities suggest that how well a ‘high inflation’ growth strategy would work could depend on the level of development of the economy. It seems more likely that such a strategy may work for an EM economy than for a developed country. Possibly for reasons related to how the various uses of money evolve with economic development, a ‘high inflation’ growth strategy would be a non-starter for developed economies. Our comments below are limited to the EM economies and their currencies:
• Point 1. EM economies choosing to accommodate inflation is a legitimate option. We sense that investors in general do not condone some EM economies taking a dovish stance toward inflation. But these EM central banks may have a case, in choosing to protect growth. The GCC countries and Russia have opted for rapid growth, despite inflation approaching 15%. This, to them, is an once-in-a-lifetime opportunity to leap forward in a short span of time, and so a bit of inflation may not be that bad. Further, given that this inflation surge is accompanied by a major terms of trade issue, there is more fiscal latitude to help minimise the social and distributional implications of high inflation. We are not necessarily endorsing the policy choice of these economies, but simply pointing out that such a choice is arguably as legitimate as the ‘stay-ahead-of-the-inflation-curve’ view that is popular among many investors. In a way, these economies are going through the same phase that Latam and Asian countries went through a generation ago. Even if the GCC were not pegged to the USD and had full monetary independence, we are unsure whether they would choose to tighten the monetary stance now to choke off economic growth in order to stabilise inflation. In the long run, however, it would still make sense for them to have a common currency and independent monetary framework. But a journey towards that end will look quite similar to the journey that began in China in 2005, in our view. A BBC (basket-band-crawl) regime to guide the GCC ‘dinar’ stronger would entail the same issues (hot money inflows and accelerating pressures to appreciate) that China is experiencing now. While the risk of a peg breaking in the GCC in the coming year is still lower than 50%, we believe that it is high enough that investors should have protection against this event.
• Point 2. The balance of the ‘loss function’. We have argued previously that, given the high food and energy weights in their overall CPI baskets, the inflation surge will pose a significant policy challenge for many EM economies. Central banks that try to stay ahead of the inflation curve will impose severe output costs, we believe. Essentially, there is a spectrum of choices on the inflation-output balance whereby central banks choose how much output loss and ‘inflation gap’ they are willing to tolerate. The combined output and inflation ‘misses’ is what we call the ‘loss function’. The Reserve Bank of India, for example, chose to have a smaller inflation ‘miss’ at the expense of possible output losses, while China and Korea have refrained from raising rates for seven and 11 months, respectively, despite the fact that inflation has accelerated in both countries. We believe that macro investors will probably reward the currencies of countries whose central banks attempt to fight inflation by raising interest rates. However, the equities of these economies may underperform because of the higher interest rates, exacerbating the energy shock that is already impinging on the economy. In a simulation, the real policy interest rates in BRIC could rise substantially relative to that of the G7 if the BRIC central banks try to stay ahead of the inflation curve.
In other words, the currency markets and the equity markets may react differently to EM’s monetary policies, depending on the balance of the ‘loss function’. Of course, the ‘loss function’ itself should vary in size across countries. This is why we are more bearish on INR, IDR and the PHP than the SGD and TWD.
A related issue is the high output losses associated with reductions in inflation back to ‘low’ levels. Russia, China and India may eventually choose to tolerate a bit more inflation, in exchange for super-normal economic growth, as the GCC economies have been doing; however, when they need to eventually arrest inflation and push it back down to the low single-digit levels, the process may be painful, in terms of economic growth. Thus, in a way, central banks are confronted with choosing to keep inflation low today, versus pushing it back down several years from now.
Using currencies to deal with inflation will likely not be too effective. First, food and energy inflation is a global problem. Exchange rate policies may make sense from an individual country’s perspective but make little sense from the world’s perspective. It is, as we have argued before, as flawed as competitive devaluation. Also, unless the currency in question could be driven continuously stronger, the exchange rate will do little to offset imported inflation. Recent interventions by Korea to cap the value of the dollar are not aligned with the underlying fundamentals. The KRW should eventually weaken, in our view.
• Point 3. Oil and commodity prices are still key. The analysis above is predicated on the world remaining in an inflationary environment. But oil prices could continue to rise, or they could fall. There is still a great deal of uncertainty surrounding these critically important prices, which will dictate the inflation trends around the world. In this note, we do not express a strong opinion on where oil and commodity prices should go, but merely assume that inflation remains high.
Bottom Line
Inflation is not always bad. The positive relationship between inflation and the output gap captured by the Phillips Curve should not be confused with the long-run relationship between inflation and growth, for which there is no clear statistical relationship. The role of fiat money is key in determining whether this relationship is positive or negative. For some EM economies, this relationship could be positive, justifying central banks protecting growth and allowing inflation to rise. Investors should be aware of the risk of EM central banks having a moratorium on inflation-targeting.
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