By Prieur du Plessis, on July 11th, 2011 posted in: Economy, Emerging markets, Inflation Leave your comment

Tweet

Email

Print This Post

This post is a guest contribution by Manoj Pradhan of Morgan Stanley.

Rather than signaling an extended period of tightening, China’s latest policy rate hike is expected to be the last of its kind in 2011. In a similar vein, policy headwinds to growth are set to ease in AXJ and LatAm, setting up the stage nicely for a rebound in risk sentiment. Even though most of the policy normalisation is ahead of us in the CEEMEA region, the overall change in sentiment should help here as well. Slowing EM growth will take some of the wind out of the sails of inflation and base effects will kick in over the next 3-4 months to push headline inflation lower, in our view. A macro environment where policy isn’t tightening further, inflation is on the decline and GDP growth is close to trend should be a potent combination for a recovery for risky assets. A final trigger for this change is the prospect for a better 2H in the US that our US team expects.

However, on a longer horizon, EM central banks don’t appear to have dealt with inflation conclusively. Risks to growth and particularly to inflation are to the upside. The ongoing inflation episode starred commodity prices while core inflation stayed benign almost everywhere. The next inflation story is likely to have core inflation in the driver’s seat. Central banks would then likely have to respond with another round of tightening. But this is a story for 2012, not 2011.

It should be noted that inflation in 2012 need not be of a rampant kind or even of a variety that central bankers will not be able to tame. Simply put, the return of EM inflation in 2012 is a risk, which implies that monetary policy tightening could also return. Until we get there, risky assets are likely to remain buoyant in the benign macro environment. In this note, we pay more attention to factors that could lead inflation higher, directing readers to our colleague Chetan Ahya’s note (Asia-Pacific Economics: Nearing the End of Rate Hike Cycle, June 30, 2011) for a detailed analysis surrounding the end of policy normalisation by AXJ central banks.

A Better Macro Environment Should Mean a Return to Risk

Inflation is set to fall in 2H11 in most of the EM economies we cover. We have argued in the past that moderate levels of inflation that most EM economies have at the moment are not a direct threat to economic growth. It is the actions of policy-makers who want to prevent inflation from rising that inflict damage on growth. If they didn’t act, inflation would likely rise to levels where it would directly hurt growth. To add insult to injury, policy-makers would have to then act even more aggressively to bring rampant inflation under control.

Oil and food inflation, which sparked the inflation scare, have been falling across the EM world. More importantly, growth is slowing to trend without a hard landing on the cards. Prima facie, there appears to be little reason for monetary policy to stay restrictive. And indeed, AXJ and LatAm central banks are close to completing the hikes they have in the pipeline for this episode. CEEMEA monetary policy was late to start rate hikes, given that the region’s economic growth lagged the other EM regions and most of the policy normalisation is therefore still ahead of us.

By that rationale, the fall in inflation – thanks in part to the growth slowdown – is likely to satisfy policy-makers and hence keep policy from getting tighter than it already is. Brazil’s monetary policy is the only one set to forge into outright restrictive territory and Turkey is likely to flirt with this boundary. However, in China and India – the other two economies where monetary policy is slightly restrictive – monetary policy is set to ease from its current slightly restrictive stance to a neutral one. In China, the policy stance could well ease over the summer and in India around six months down the line. This should set the stage nicely for a return to risk.

Caveat Emptor – The Second Coming of EMflation…in 2012

However, something will eventually have to give from the combination of falling inflation, economic growth at trend and policy rates on hold. Not just because it always does, but also because we argue that EM policy-makers, fully cognisant of the risks to US and global growth, have not been aggressive enough to put a more lasting dent in inflation. Our simple argument in this note is that, if these risks abate, and our economics teams expect them to, then the cyclical risks to EM growth and particularly to inflation are to the upside.

A familiar side-effect of better-quality global growth is higher commodity prices. However, unlike the 1H11 episode of EM inflation, it is not commodity shocks that are central to our argument here. Rather, it is that policy on hold and growth at trend render the EM world susceptible to upside risks, as we discuss below.

In addition to the cyclical arguments, structural drivers should keep inflation risks to the upside. Rather interestingly, the structural issues are set up such that EM inflation can rise even without an increase in the current level of EM growth.

Continue reading Emerging economies – short-term gain, longer-term pain?