Challenges of two speed world recovery
What’s at stake
The difference between cyclical positions in the US and other large developed economies, on the one hand, and in China and some of the larger EM economies, on the other, is creating difficult challenges for policy makers. Rising inflation in the emerging world is fast becoming a headache for the global economy as data suggested that the China, the UK and the euro area are both struggling to contain price pressures. A key question to national central banks is the extent to which such imported inflation should be accommodated. With euro zone inflation above the ECB’s sub-2% target for the first time in over two years, and ECB officials sending hawkish signals of late (see important Bini Smaghi speech below), price pressures are being scrutinised more closely than usual in the euro bloc.
The distribution of world aggregate demand
John Kemp, a Reuters economist, argues that at a global level it is not clear that there is an output gap. Rapidly rising food and energy prices suggest that the world economy is already hitting the speed limit of non-inflationary growth. While factories across North America and Western Europe are idle, Asia’s manufacturers are booming, and commodity producers are struggling to source sufficient oil, iron ore and copper. This suggests that global growth is already hitting supply side limits and that there is not much that demand management can do in the face of it.
Paul Krugman writes that this is, indeed, a fair picture of what’s going on. The more questionable assertion is that “the problem is not aggregate demand but its distribution.” In fact, it’s both. Production has recovered the ground lost during the recession, but it’s still only slightly higher than the previous peak, which puts it well below any reasonable estimate of trend. But this overall picture hides a sharp divergence between advanced and emerging economies. Emerging economies are well above previous peak, and arguably more or less back to trend. Advanced economies, however, are still well below pre-crisis output, let alone the pre-crisis trend. No wonder, then, that we’re seeing inflationary pressures in the South even as disinflation remains the rule in the North. But what this says is that if global aggregate demand were redistributed, so that more of it fell on advanced countries, we could expand further without putting pressure on capacity worldwide.
Olivier Blanchard points to the tensions and risks this uneven global recovery is creating. The first is rising commodity prices. In fact, the problem is not quite as severe as headlines would suggest, as actual prices remain below their pre-crisis peaks. Moreover, food price increases have been driven mainly by one-time supply-side factors, and the effects should wind down over the course of 2011. However, oil price pressures are different. They come from the demand side. In the second half of last year, unexpected consumption growth of 2% resulted in a price increase of roughly 10%. Strong world growth is likely to be associated with further increases, with important implications for emerging and developing economies. The second is capital flows into emerging markets. Here again, the problem is not quite as bad as the headlines would suggest. Inflows have definitely increased, but for most countries, they remain below previous peaks and have actually been receding in the last couple of months. Nevertheless, these flows raise difficult policy choices, from the degree to which countries should allow for currency appreciation, to the respective roles of macroeconomic policy, macro prudential tools, and capital controls.
Luis AV Catão and Roberto Chang writes in VoxEU argue that global food price pressures not only pose a sizeable threat to global monetary stability but also pose an externality problem that demands non-trivial coordinated action by key central banks. The authors document that every single inflation upturn over the past four decades has been preceded (with a one to two-year lag) by an uptick in world food prices. For the ECB and the US Federal Reserve, two considerations stand out. The first is that their actions have a direct bearing on global food price given their weight in world income and capacity to set world interest rates, influencing food prices via both demand and supply channels. The second is that their actions have strong externalities elsewhere. In the emerging/developing world, this can be far-reaching because food accounts for a very high share in consumer spending and, since much of it consists of non high-end items, it cannot be substituted away.
The Institute of International Finance estimates that investment and cash flows to emerging nations will surge to nearly $1 trillion dollars this year, adding pressure to developing economies already overheating. Strong expansion in Asia and Latin America, combined with low interest rates and sluggish growth in advanced economies, are the main factors fueling the capital flows. The group forecasts $960 billion moving from rich to emerging economies in 2011 and topping $1.04 trillion next year.
How should policy makers in advanced economies react?
ECB board member Lorenzo Bini Smaghi said in an important speech on Thursday that core inflation is obviously losing its relevance in a global world. Imported inflation from emerging countries can no longer be ignored, and central banks on the receiving end might need to tightly constrain domestic inflation to compensate. We can expect that commodity, energy and food, will continue to grow in line with global demand, unless technological innovations are such that they lead to changes, which offset the quotations. Unlike the previous decade, the process of reducing the prices of manufactured goods imported from developing countries seems to have ended, particularly in respect of products imported from China. Only by having domestic inflation significantly lower than 2% is it possible to avoid second-round effects on expectations and to maintain an economic growth rate in line with potential. Mr Bini Smaghi illustrates the problem with a hypothetical example in Europe. If inflation of 4 per cent is affecting the imported 30 per cent of the basket, he says, then the ECB would face 1.2 per cent inflation from the outset. Given a target of 2 per cent inflation, this leaves a gap of 0.8 percent for domestically generated inflation. Given 6.5 per cent imported inflation, domestic inflation would need to be zero.
Real Time Economics writes that Bini Smaghi must have forgot to tell the Fed, which said in Wednesday’s FOMC statement that although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward. Measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.
Samuel Brittan argues that the right strategy is certainly not to depress advanced economies until commodity prices face a demand check. Still less by trying to depress domestic prices to make up for rising prices for raw materials and fuel from outside their area. Martin Wolf argues that it makes next to no sense to raise unemployment, in order to drive down wage inflation even further, with a view to offsetting the inflationary impact of something inherently uncontrollable. It is impossible to predict the direction of the more volatile world prices. True, the government’s chosen measure of inflation includes externally driven prices. Yet, given the uncertainty about their likely evolution, it makes far more sense to focus on domestic costs.
How should policymakers in emerging economies react?
Gavyn Davies notes that food and energy accounts for almost half of the CPI in emerging economies like China and India, and only around 15 per cent in the US. The emerging world is therefore facing a much more urgent need to tighten monetary policy, despite its widespread reluctance to do anything which increases upward pressure on its currencies. Real policy rates in many emerging economies remain below zero, so policy is still extremely accommodative. There are serious questions about whether policy makers will turn a partial blind eye to rising inflation, in which case property and equity markets in some economies might enter bubble territory. And commodity prices could continue to rise, doing a lot of damage to growth and inflation in the developed world as well.
Tim Duy argues that if inflation abroad is a problem, it is one that emerging markets need to tackle themselves. It is not because the Federal Reserve has set rates too low, but because emerging markets
been unwilling to allow their currencies to appreciate sufficiently against the Dollar. Given that the Fed is not likely to back down from this fight, emerging markets need to put the brakes on their internal inflation issues, the sooner the better. Otherwise they will be facing pain of a real inflation crisis, one that requires stepping on the brakes even harder. How this story unfolds this year will determine of the global economy can transition to a sustainable, balanced growth trajectory, or plunges into yet another of the seemingly all-too-frequent crises.
Stephen Roach argues that the lessons of earlier battles against inflation are clear on one fundamental point: inflationary pressures cannot be contained by negative, or slightly positive, real short-term interest rates. The only effective anti-inflation strategy entails aggressive monetary tightening that takes policy rates into the restrictive zone. Benchmark policy rates are currently below headline inflation in India, South Korea, Hong Kong, Singapore, Thailand, and Indonesia. They are only slightly positive in China, Taiwan, and Malaysia.
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