Monetary polic
The power now being unleashed by emerging countries like China, India, Russia and Brazil threatens to upset all best-laid economic plans. Relative to the US, none of the emerging economies is, on its own, particularly large. Each of them has only a modest individual gravitational pull. But they are all growing rapidly. Their inflation rates are rising furiously. And, collectively, they are about the same economic size as the US.
Most of them tie their monetary policies to those of the Federal Reserve through the use of currency pegs or managed floats against the US dollar. When, therefore, the US cuts interest rates it is loosening monetary conditions not just in the US but also in many parts of the emerging world as well. However they are not suffering from any economic slowdown. As a result, looser US monetary policy, while rescuing beleaguered US households and banks, is also lifting emerging world inflation.
This is like having an imaginary monetary union involving the US and all the emerging economies. If this were the case the Federal Reserve will no longer look after monetary policy for the US alone, but instead set interest rates for the good of the monetary union. The "one size fits all" approach would surely force the Fed to raise interest rates from where they are today because inflation in this imaginary monetary union is currently averaging about 6 per cent (and rising).
The western response to this problem is to demand that emerging economies sever their ties against the dollar and allow their currencies to appreciate. Their inflation rates would then come down through a combination of cheaper imports and higher domestic interest rates. There is, though, a major problem with this approach. Japan followed this policy in the late 1980s, and Brazil has followed a similar strategy over the last few years. In both cases, though, inflation pressures were only temporarily suppressed rather than removed altogether.
The dollar peg regimes worked well when the emerging markets were small and played an insignificant role on the global economic stage. Now they are big and need their own independent monetary regimes. But what should those regimes look like? Inflation targets will work well because so much of the inflation in the emerging world comes from food and energy prices, which are all over the place from one year to the next. Money supply targets never worked well in the developed world and, with only rudimentary and sometimes unstable financial systems, emerging economies are unlikely to fare much better.
In this policy vacuum, emerging market policymakers have adopted what amounts to a very simple strategy. That is to hope for the best. They are mostly taking the view that, with the US softening, their exports will slow. Commodity prices, meanwhile, will drop. Both effects should reduce inflation.
But emerging economies are now so big, why should a slowdown in the US lead to falling commodity prices? Increasingly, countries like China are global price setters. They determine the global price of oil, of metals and of food. Hoping that, somehow, a US slowdown will lead to diminished global inflationary pressures no longer rings true.
This is a bit of a throwback to the 1970s. At the beginning of that decade, the Bretton Woods exchange rate system collapsed. For years afterwards, countries struggled to find an alternative monetary system and, in the process, lurched from one economic upheaval to the next.
It is not that easy to throw out one system and replace it, overnight, with another. Our world of inflation targeting and stable economic prospects is most often taken for granted, forgetting the strife that got us to this point. The emerging economies, like the developed economies before them will have to go through growing pains and learn from their mistakes.
Will developed economies be able to cope? It looks as though inflation has its origin in the emerging world. Rising food and energy prices owe a lot to the extraordinary strength - and overly loose monetary conditions - in China, India and the rest. To meet inflation targets, central banks need to ensure that food and energy price increases be matched by price decreases elsewhere. Easier said than done.
It is probably wrong to assume that food and energy prices will come down anytime soon. Indeed, if the emerging economies adhere to their "do nothing" strategies, there is a good chance that food and energy prices will continue to rise, which translates into higher food and energy costs. If these costs are rising, other costs will have to fall. In an inflation targeting context, that means lower wages and profits. To deliver this, monetary policy may have to remain tight, even in the light of subdued economic conditions.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Most of them tie their monetary policies to those of the Federal Reserve through the use of currency pegs or managed floats against the US dollar. When, therefore, the US cuts interest rates it is loosening monetary conditions not just in the US but also in many parts of the emerging world as well. However they are not suffering from any economic slowdown. As a result, looser US monetary policy, while rescuing beleaguered US households and banks, is also lifting emerging world inflation.
This is like having an imaginary monetary union involving the US and all the emerging economies. If this were the case the Federal Reserve will no longer look after monetary policy for the US alone, but instead set interest rates for the good of the monetary union. The "one size fits all" approach would surely force the Fed to raise interest rates from where they are today because inflation in this imaginary monetary union is currently averaging about 6 per cent (and rising).
The western response to this problem is to demand that emerging economies sever their ties against the dollar and allow their currencies to appreciate. Their inflation rates would then come down through a combination of cheaper imports and higher domestic interest rates. There is, though, a major problem with this approach. Japan followed this policy in the late 1980s, and Brazil has followed a similar strategy over the last few years. In both cases, though, inflation pressures were only temporarily suppressed rather than removed altogether.
The dollar peg regimes worked well when the emerging markets were small and played an insignificant role on the global economic stage. Now they are big and need their own independent monetary regimes. But what should those regimes look like? Inflation targets will work well because so much of the inflation in the emerging world comes from food and energy prices, which are all over the place from one year to the next. Money supply targets never worked well in the developed world and, with only rudimentary and sometimes unstable financial systems, emerging economies are unlikely to fare much better.
In this policy vacuum, emerging market policymakers have adopted what amounts to a very simple strategy. That is to hope for the best. They are mostly taking the view that, with the US softening, their exports will slow. Commodity prices, meanwhile, will drop. Both effects should reduce inflation.
But emerging economies are now so big, why should a slowdown in the US lead to falling commodity prices? Increasingly, countries like China are global price setters. They determine the global price of oil, of metals and of food. Hoping that, somehow, a US slowdown will lead to diminished global inflationary pressures no longer rings true.
This is a bit of a throwback to the 1970s. At the beginning of that decade, the Bretton Woods exchange rate system collapsed. For years afterwards, countries struggled to find an alternative monetary system and, in the process, lurched from one economic upheaval to the next.
It is not that easy to throw out one system and replace it, overnight, with another. Our world of inflation targeting and stable economic prospects is most often taken for granted, forgetting the strife that got us to this point. The emerging economies, like the developed economies before them will have to go through growing pains and learn from their mistakes.
Will developed economies be able to cope? It looks as though inflation has its origin in the emerging world. Rising food and energy prices owe a lot to the extraordinary strength - and overly loose monetary conditions - in China, India and the rest. To meet inflation targets, central banks need to ensure that food and energy price increases be matched by price decreases elsewhere. Easier said than done.
It is probably wrong to assume that food and energy prices will come down anytime soon. Indeed, if the emerging economies adhere to their "do nothing" strategies, there is a good chance that food and energy prices will continue to rise, which translates into higher food and energy costs. If these costs are rising, other costs will have to fall. In an inflation targeting context, that means lower wages and profits. To deliver this, monetary policy may have to remain tight, even in the light of subdued economic conditions.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
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