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.
Kicking the EMflation Can Down the Road
While this phrase has become synonymous with problems in another part of the world, it is quite apt in the present context as well. From the extent to which policy was normalised to the degree to which growth was reduced, EM policy-makers appear to have simply pushed forward the day of reckoning as far as inflation is concerned. They may have done so in complete awareness, given questions about sustainability of growth in their biggest export market or the turmoil in Europe, or they may have unwittingly done so by not taking into account the structural factors that are likely to drive inflation.
We first discuss the cyclical arguments that suggest we haven’t yet found a lasting solution to the EM inflation problem, and proceed after that to discuss structural factors which lend weight to this proposition.
Cyclically Speaking
So why do growth heading towards trend, policy at neutral and falling inflation suggest cyclical inflationary pressures next year? Normally, falling inflation would suggest rising real rates and tighter policy. This time round, however, falling headline numbers mask sequential inflation number which we expect will remain robust, suggesting that real rates will not rise much using the latter measure of inflation. Headline inflation is also falling because oil and food price inflation is abating, but this should feel like policy easing, not tightening, to the economy.
From a policy perspective, only four central banks (the central banks of EM majors China, India, Brazil and Turkey) are or will be on the restrictive side of neutral. All others are either likely to stay in expansionary territory or move from expansionary to neutral without really tightening. Many central banks (particularly the four mentioned above and Russia) have done a large part of their tightening using quantitative tools, but not via higher policy rates. As a result, real policy rates are still quite low even as fiscal policy remains loose in most countries.
Finally, DM growth will likely remain a key trigger. EM central banks have been cautious in their tightening because of the uncertainty surrounding DM growth. We are already seeing a return of risk appetite as data flow in the US suggests less downside than markets had feared. Sustained growth, particularly in the US, should have a large impact on export-oriented AXJ economies and commodity-exporting LatAm economies. The CEEMEA region, as always, is a more mixed picture, with commodity-exporting Russia, South Africa and the Middle East likely to benefit from better US growth but Central European countries likely to have less buoyant growth because of the downside to European growth that our team expects.
Policy Rate Hikes Do Not Always Mean Tighter Policy
EM central banks have hiked rates at a pace that fell short of taking real policy rates in line with the growth and inflation cycle. We illustrate our economists’ perception of where the current stance of monetary policy is and where it is likely to end up in 6-12 months. In line with the argument made above, not a single central bank under our coverage is in anything more than a ‘just restrictive’ stance. Even over the next 6-12 months, the only policy stance that is likely to push into outright restrictive territory is the much-debated one of the Central Bank of Turkey. The PBoC and the RBI are likely to turn from their restrictive stance back to a more neutral one, with the PBoC going soon, perhaps even over the summer, and the RBI to follow in about six months or so.
Inflation Deflates Rate Hikes
There are two ways to see that policy has not kept pace with the economic cycle. First, since inflation has been on the rise over the time that policy rates were being hiked, real policy rates are still very low. The cases of Korea, Indonesia and Malaysia demonstrate this point well. Despite rate hikes, the policy stance of these central banks remains in accommodative territory because inflation has been at least as quick to rise. In the case of India, the speed with which inflation has risen has meant that even the rapid rate hikes delivered put policy only in the mildly restrictive zone. In the case of China, even though credit growth is the primary instrument of monetary policy, nominal policy rates at 6.5% and inflation printing at 5.5% mean that real policy rates are still only around 1%.
The EM Monetary Policy Cushion
Second, policy rates have not kept abreast of the lack of slack in the economy. We illustrate that EM economies have real policy rates far too low compared to where real GDP growth is. As a result, the EM ‘policy cushion’ seems out of sync with the EM outperformance in the global two-track economic recovery. Of course, part of the reason that GDP growth and the policy cushion is small for DM economies is that they inherently have low growth rates and inflation rates. However, the economies that have the largest policy cushion include EM countries that have a higher risk of overheating than of slumping. For example, India, China, Taiwan and Peru have some of the largest policy cushions around, but are also economies that we consider have no slack at all in the economy.
QT
The public face of EM monetary policy has been a proactive one. Aggressive quantitative tightening in the BRICs and Turkey via FX intervention, RRR hikes and liquidity-draining operations in the money markets have probably created an impression of aggressive monetary tightening. However, these QT policies in the EM world are a direct response to the QE policies employed in the DM economies. QT tools were employed to counteract and have been successful in dealing with the build-up of liquidity in the banking system that resulted from QE. In Turkey, for example, banks are paying in the neighbourhood of 10% for 1-month retail deposits. QT has helped policy gain traction but cannot be considered a substitute for traditional monetary policy. Why? QT policies work through the banking channel of monetary transmission and account for a significant but not a major part of the transmission of monetary policy. Traditional monetary policy transmission is broader and continues to be more effective in macro management.
And Fiscal Policy Is Loose as Well
It is not just monetary policy that is supporting growth. Substantial fiscal support continues to lurk in the background without making any headlines. Fiscal policy is bulky and difficult to reverse, and has outlived its role in reviving EM economic growth. In some countries like India, Brazil and Chile, it may actually be proving counterproductive by keeping inflationary pressures high and disincentivising private investment there. If fiscal policy stays loose, the theoretical policy mix prescription suggests that monetary policy will have to tighten more than usual to compensate. This has clearly not been the case.
The End of Monetary Policy Normalisation
EM monetary policy is headed towards the ‘neutral’ zone. In some cases, it has put in a brief stay in slightly restrictive territory (China and India being the notable examples here), but most are happy to turn neutral without really tightening monetary policy too much or even at all. In the important cases of EM giants China and India, the normalisation of monetary policy still leaves substantial stimulus in place. For example, ample fiscal stimulus remains in place in India in the form of public spending, whereas the loan surge that catapulted China away from danger during the Great Recession is still in the system in the form of a massive expansion of private spending via credit growth.
Base Effects versus Sequential Drivers
Lower growth has certainly taken some fuel out of the inflation fire, but a significant part of the decline in the year-on-year headline inflation comes from statistical and predictable base effects. However, it is the very statistical and predictable nature of these base effects that keeps them from having any economic significance. The jury will be out for a quite while on whether monetary policy and slowing growth have been enough to bring down inflation on a sequential basis. In other words, the proof of the pudding will be in the taste of the month-on-month inflation numbers. We will be watching these very carefully. To the extent that sequential inflation remains strong, headline inflation could remain stubborn and even start rising again when the base effects weaken.
Upside Risks to Growth
The above discussion raises the obvious question: are EM central banks behind the curve? In an autarkic sense, yes. However, they are part of the global economy and the risks to global growth are an intrinsic part of the EM policy equation. In this sense, their desire to protect domestic growth when external demand is uncertain is understandable and entirely reasonable. Historically, EM policy-makers have always given greater weight to growth than inflation. The policy stance depicted in Exhibit 2 in the full report is consistent with the desire to engineer a soft landing and take domestic growth down to trend, not lower. Correspondingly, inflation will have no more tailwinds, but no real headwind either.
Returning growth to trend without normalising all policy support puts the risks to domestic economic growth to the upside. Just above we have noted that even though no further tightening is expected in some of the major AXJ and LatAm economies, monetary and fiscal support provided during the dark days of the Great Recession are still in the system. This suggests that domestic demand is still being propped up and is likely to rise again once monetary policy tightening draws to a pause. External demand also faces upside risks. The improved performance in the US that our US team forecasts implies that export growth is unlikely to collapse again. Together, EM growth has the potential to surprise to the upside after spending a little while close to trend.
Core Inflation to be Front and Centre
The cyclical policy and growth story outlined above puts core inflation at risk. The 2010 inflation surge was all about food price shocks and a spike in oil prices thanks to events in the Middle East. Throughout this episode, core inflation has risen but from relative low levels for most EM economies and remains benign relative to headline inflation. Core inflation is quite high in India, Korea, Brazil and Russia, and is low at 2.4% (relative to headline inflation at 5.5%) for China, which still represents the highest print for nearly a decade. The next time, we argue, will be different for the cyclical reasons we have just outlined. We turn next to the structural drivers of EM inflation.
Structurally Speaking
Inflation is not just a cyclical issue. In past notes, we have highlighted how higher productivity in the EM world has been driving EM currency strength in real terms for the better part of a decade now. The real exchange rate appreciation has direct implications for inflation. This is a pre-crisis story that has more than survived the Great Financial Crisis and the Great Recession. However, the crisis and ensuing recession have most likely created structural changes that need to be addressed as well. In particular, lower potential output growth is a reality not just in the DM world but also for EM economies. The implication is that growth cannot be sustained at pre-crisis levels for long periods of time without overheating and inflation.
Lower Potential Output Growth and Inflation
First, we address the issue of lower potential output growth. There are at least three reasons to think that EM potential output growth is likely to be lower than it was before the Great Recession:
Shock to DM permanent incomes = shock to EM exports: Milton Friedman’s Permanent Income hypothesis argued convincingly that shocks to ‘permanent’ rather than ‘transitory’ income were likely to result in lower consumption. Households that can recognise transitory shocks to their income are likely to smooth their consumption over time by borrowing against their future incomes. If the ‘permanent’ component of incomes are affected, however, then households are not as willing to borrow against future income since that too has fallen. In a textbook treatment, consumption falls in the latter case but not in the former.
Such a shock to permanent incomes has indeed hit DM households. Consumption for these households is unlikely to return to the frenetic pre-crisis pace, nor should it. The shock to permanent incomes and consumption directly translates to a shock to EM exports and indeed to the entire EM export-led growth strategy. It is no surprise that export-led EM economies are eager to switch to domestic demand-led growth while consumer-oriented DM economies are trying to leverage their weaker currencies and export sectors. For the economies that depend on exports and export-oriented investment to drive growth, the shock to DM permanent incomes must mean lower potential growth.
Slow transition to domestic demand-led growth: The domestic demand-led growth that EM economies seek is a way out of this quagmire. However, the transition to such a model is going to be a slow one. Besides the shock to export growth described above, periods of transitions by their very nature are periods of uncertainty. As efforts are made to boost consumption and less emphasis is given to exports and export-oriented investment, potential output growth will likely be weak for the medium term.
Adverse demographics: Finally, a much slower moving force, but a mighty one, is playing out in the background. The world is getting old – literally. The debate about the adequacy of DM pension systems to support its ageing population has been around for a while now. However, EM economies are also getting old and the debate is now beginning to receive the attention it deserves. EM economies are younger at the moment, and have lower dependency ratios, but will likely age faster. While the EM-DM divide falls (again) squarely on the side of the EM world, the country-wise breakdown throws up some interesting comparisons. Our illustration suggests that China and Korea’s young populations will age more rapidly than that of the US, with the process starting after just a few years. There are exceptions to this trend – including India, Indonesia, Brazil, Mexico, Turkey and South Africa – where demographics stay supportive for quite a while more. The bottom line is that the demographic story is less supportive of growth in the DM world and to a lesser extent in the EM world, which implies that potential growth will face headwinds on this score globally.
The Implications for Inflation
The implications for inflation are clear. A lower potential output growth by itself means not just that economic growth and development will be slower, but also that the pre-crisis level of output growth is not a sustainable one. For inflation, lower potential output growth is not a problem as long as this change is recognised by policy-makers. Such a recognition may not be widespread or believed with strong conviction. If we are right, then what used to be an economy growing close to trend (point A in our illustration) will now mean an economy that is growing above (a lower) trend (depicted by distance AB). If policy-makers perceive that they are at point A but are actually facing an output gap of AB, then inflation is just down the road. The structural issue of potential growth can thus have economic implications at the cyclical horizon.
Rebalancing and Real Exchange Rates
A last but important driver of inflation is the powerful force of global rebalancing manifested in the real appreciation of EM currencies. With the renminbi pegged or appreciating very slowly against the US dollar and most other EM policy-makers reluctant to allow their own currencies to appreciate against the renminbi (for fear of losing competitiveness), there has been not enough by way of EM currency appreciation against the dollar, though recent signs have been encouraging. In the absence of this appreciation, a large part of the real appreciation has happened through EM inflation running higher than DM inflation. If the status quo remains on the currency front and as DM inflation rises, structural forces should continue to pressure EM inflation higher.
Summary
EM economies are likely to get some much needed relief as growth slows to trend, inflation falls and policy normalisation ends in most places. Risk appetite is likely to rebound on such a benign outcome. However, in our opinion, much of the tightening, particularly for central banks in restrictive territory, has been done via quantitative tools so that policy rates are still very low while fiscal policy remains loose. In addition, our US economics team expects a better 2H performance there. This implies that there are upside risks to EM growth and inflation. Structurally speaking, lower potential output growth and ongoing real exchange rate appreciation continue to pressure inflation higher even if EM growth doesn’t rise. The upshot is that monetary policy in EM economies might be done normalising, but there may be more work to do in 2012 if these upside risks are realised. For now, there is a period of calm to be enjoyed.
Source: Manoj Pradhan, Morgan Stanley, July 8, 2011.
