- Inflation risk in EMs remains to the upside - The risk does not abate if annual CPI growth rates peak - Currency revaluation would be the best solution - Beijing has to be the first to act

By Greg Peel

Before we get started, to appreciate the following discussion it is necessary to understand “base effects” with regard to inflation measures.

Let's say for the case of argument that a country's consumer price index rises 0.5% one month, 1.0% the next month and then 0.5% the following month. That 1.0% blip is due, let's say, to a sharp spike in petrol prices.

On the first month's result, we see CPI inflation running at 0.5% growth. With the second month's result in, we can average the moves to show 0.75% growth over two months. Throw in the third month, and our average becomes 0.66% over three months. So while each month saw a period of CPI growth, the move from the second month to the third month still registered a fall in the average rate of CPI growth.

Now let's expand the example to assume we have been measuring monthly CPI moves for some time, and that each month we note both the month-on-month move and the move over twelve months, eg March from February and March from March last year. As our three month example shows, it is possible to have the inflation rate rising month-on-month, in an individual monthly result, but falling year-on-year. The opportunity to have differing changes grows when we consider that, in the second case, we are not looking at a running average but a twelve-month result. It means that when we shift to comparing March-to-March, last February's result drops out of the other end of the measure.

In our first three-month example, that oil price spike shifted the oil price “base” within the index higher. Indeed, each month the prices used to calculate the CPI are re-based before the next month's comparison is made. In our twelve-month reality, the price bases are constantly shifting as an old month drops off the end.

Here endeth the lesson.

“While inflation in a large part of the EM [emerging market] world is poised to peak around the middle of the year on a year-on-year basis thanks to strong base effects,” notes Morgan Stanley's London-based economist Manoj Prahdan, “what level it will peak at and how quickly it will fall will be significant in determining the policy response from EM central banks. In other words, central banks are likely to pay close attention to the sequential change in inflation after stripping out the base effects”.

What Prahdan is essentially saying here is that it would be foolish for EM central banks to simply breathe a sigh of relief and say “Thank God that's over” when year-on-year inflation rates start to decline, given re-basing masks the reality of ever upward month-on-month inflation growth. The “other” EM members would have received a wake-up call recently when China's headline CPI printed a higher than expected 5.4%, prompting the central bank to immediately tighten monetary policy once more via another 50bps increase in the bank reserve requirement ratio. Then came an upside inflation surprise from India as well, and attention would have been piqued.

Morgan Stanley suggests EM inflation risks remain skewed to the upside. Higher oil prices and higher producer price inflation in general could potentially pass into all other prices in the economy, and hence the CPI. Ongoing Middle East tensions suggest a risk of further oil price upside. Were the oil price to rise to US$140/bbl (MS does not specify which oil price here) and global trade be reduced by 5%, Morgan Stanley economists calculate global inflation would rise by 100 basis points in 2011 and global GDP growth fall by 100 basis points. If oil prices rise because of increased demand for oil, then inflation would rise but the global economy would grow. If, however, oil prices rise because of a “supply shock”, such as a loss of Middle East production, then inflation would rise but growth would fall – the spectre of stagflation.

In most EM economies, including Brazil, Russia, Latin America and Israel, base effects should push annualised inflation lower in the second half of 2011, notes MS. India, Turkey and South Africa will not see a reduction from base effects. In the meantime, producer price inflation (ie increasing input price costs) and imported inflation (rising cost of imported materials and goods) have continued to rise for the EMs.

The oil price is a big culprit here, given a higher price of oil impacts inflation both directly and indirectly via pushing up the price of everything. Producer price inflation is likely also rising anyway, suggests MS, given there is little or no capacity slack in EM economies, and import price inflation has been aided by a reluctance among currency-peg economies to allow sufficient nominal appreciation.

As we know from Beijing's frustrating “softly-softly” approach to currency revaluation, the reluctance of EM economies to revalue too quickly stems from a fear of the ongoing fragility of the global economy and the risk of derailing EM growth and causing a “hard landing”. If inflation is due overall to higher oil prices, then currency appreciation could provide relief, MS suggests. If producer prices are rising due to the growth in domestic demand, then higher interest rates should be the answer. Either way, EM caution likely means inflation risks will be skewed to the upside.

EM currencies have experienced “real” currency appreciation for the better part of a decade now, notes MS, but the moves have almost entirely been the result of rising inflation rather than any meaningful appreciation in nominal currency (ie moving up currency pegs). If smaller EMs are to compete in the market place with China they cannot allow their currencies to revalue against the renminbi. As Beijing has been slow in appreciating the renminbi against the US dollar, basically the entire EM world is “soft-pegged” to the US dollar, MS notes. The upside inflation risk is thus amplified through the EMs if Beijing reacts too slowly.

Which brings us back to our “base effect” argument. EM economies can mostly live with even higher inflation for a while before economic growth is impacted, MS suggests, but if high inflation becomes entrenched then GDP growth will start to suffer. The risk is that those EM economies about to experience an apparent decline in year-on-year inflation growth fail to see sequential inflation growth becoming entrenched. When the penny finally drops, much more severe policy moves are required to prevent a rolling collapse. One is reminded that the US Federal Reserve did not have a mandate to control inflation prior to the eighties, but then persistent high inflation in the seventies led then chairman Paul Volcker to hike rates severely and thus orchestrate an early eighties recession in order to prevent something far worse down the track.

As MS suggests, most central bankers these days like to “bruise” economic growth from time to time to keep inflation in check in order to prevent runaway inflation prompting some serious injuries at a later date.

The best thing about nominal currency appreciation as a monetary policy tool is that it equates to a sort of “rate hike by stealth”, MS suggests. Actual rate hikes draw glaring media attention and spark panic among investors. Nominal appreciation would be the most sensible tool for EM central banks who should be keeping a weather eye on sequential inflation and not just re-based annual inflation.

But if the “other” EMs won't move if China won't, then it all comes down to China. Economists are expecting China's annual inflation rate to peak in the second half but will Beijing then make the mistake of relaxing?

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