Sunday, May 25, 2008

'The Economist' calls for monetary tightening

The Economist feels that inflation is a cause for greater concern for developing countries and estimates that more than two-thirds of world population may be struggling with double-digit inflation by mid-summer. Inflation has touched highs in Russia, Indonesia, China, India, Thailand and many other emerging economies.

That this inflationary surge has been driven by oil and food prices is the major concern for the developing economies, and especially the poor. Food accounts for 30-40% of the consumer-price index in most emerging economies, compared with only 15% in the G7 economies.

The Economist feels that though supply side shocks were the initial cause for food price rises, if monetary conditions were tighter, rises in food prices might have been offset by declines elsewhere thereby keeping inflation under control. It also argues that since general inflationary pressures, including wage demands, are more closely dependent on food prices in developing countries, monetary policy may have a greater role in anchoring inflationary expectations. The prescription is therefore to tighten monetary policy and raise interest rates.

For long, it has been thought that inflation should be primary concern of Central Banks in developed economies, whereas emerging economies' Central Banks have to strike a balance between inflation and growth. It is one of the interesting ironies that influential opinion makers like The Economist are now advocating that growth should be the central concern for economies like the US (and hence the need for lowering interest rates, which was being advocated till some time back), while inflation should be the primary concern of Central Banks in emerging economies.

It is well established that businesses in developing economies face higher cost of capital, which reduces their competitiveness. This is all the more so since bank loans are still the major source of financing in these countries. A more intergrated and globalized economy makes the businesses more un-competitive in the face of higher domestic interest rates. The consequent reliance on External Commercial Borrowings (ECBs) is a more dangerous solution, with the attendant risks of exchange rate appreciation and inflation pressures.

At a time when interest rates in the developed economies are at historic lows, with the real rates being in negative territory in the United States, any raising of interest rates in the emerging economies may generate undesirable incentive distortions. It could set in motion active carry trade channels between emerging and developed economies. This in turn will force up the exchange rates of the emerging market currencies, thereby lowering their export competitiveness, and also stoke inflationary pressures arising from the massive inflows of foreign capital. Besides it would also add to the debt service burden as emerging market Central Banks would then be forced to release market sterlization bonds to mop up the excess liquidity, and pay the higher rates.

The emerging economies like India now face the twin challenge of sustaining the growth of their interest rate sensitive industrial and service sectors, while at the same time insulating the large number of poor people from the high foodgrain and energy prices. On the face of it these are contradictory challenges, which require diametrically opposite solutions. Sustaining high growth rates requires keeping rates low, whereas inflationary pressures forces up the interest rates.

Faced with high commodity and input prices, appreciating currencies, and weakening demand in the US and other developed markets, many emerging economies are experiencing downward growth pressures. In the circumstances, high interest rates will only exacerbate the situation and potentially choke off the fledgling growth. In any case, the high foodgrains and energy prices are not the result of any loose monetary policy but the result of supply failing to keep up with a rapidly growing demand. This rise in demand is itself the inevitable consequence of the spectacular economic growth in these economies this decade. It is therefore highly unlikely that monetary tightening will help control this cost-push inflation scenario.

All these monetary policy driven analysis of inflation in emerging economies also misses the fact that they have been growing at very high and possibly unsustainable rates for some time now, and overheating was inevitable. It was only time before inflationary pressures became evident. Historically (as in Japan and East Asia in the seventies and eighties), similar situations in growing economies have been better managed by keeping interest rates low, even at the cost of slightly higher inflation.

The higher food and energy prices will need to be managed by strenthening and better targetting of social security measures. Governments will have to pay more attention to issues of food security and providing basic foodgrains to the poorest at affordable prices, thereby insulating them from the inflation concerns.

As the graph indicates, foodgrains contributes about 60% of the consumer price basket in India, and to that extent the inflation figures are a skewed representation. The situation is the same for most emerging economies. To that extent the core inflation (stripped off food and energy prices) may be much lower.

The advocacy of tighter monetary policies in emerging economies now only highlights the fact that the old-style "Washington Consensus" policy-mix is still alive and ready to be dusted up whenever developing economies face a crisis. It was the same during the East Asian crisis in late nineties, as is now. The Economist was at the forefront of the monetary tightening movement then and so are they now. As they say, some things never change!

1 comment:

salmanspeaks said...

The current "Irrational Exuberance" in commodities space is a fallout of low interest rate policy of Ben Bernanke. It is high time that Ben Bernanke should start with tightening of monetary policy.