International Economic Update
Global Rebound Brings Signs of Inflation
January 26, 2011
As the global economy continues to recover, fears of a double-dip recession are receding. However, the strength of the economic recovery differs between advanced and emerging economies. Gross domestic product (GDP) growth for the advanced economies is held down by excessive debt. Strong growth in emerging economies is attracting an influx of capital. Inflationary concerns are building from emerging economies’ reaction to increased capital inflows.
Debt Burdens Advanced Economies
High debt levels in the advanced economies are preventing growth acceleration. Chart 1 shows the difference in general gross government debt for the advanced and emerging economies. Though government debt is a good indicator of the different debt levels between the advanced and emerging economies, it downplays the high debt levels of the advanced economies. Gross government debt represents only a small portion of total debt in the advanced economies. Household, financial and nonfinancial sectors hold the majority of the debt (Chart 2).
Advanced economies must deleverage unsustainable debt levels to achieve stable long-term growth. Though necessary, deleveraging will lead to slower economic growth. Fiscal austerity measures dampen consumer spending through increased taxation and decreased stimulus. As household, financial and nonfinancial institutions work to decrease debt, savings increase and consumption decreases. Thus, low aggregate demand is stalling growth pickup, leaving considerable slack in the advanced economies. This is most evident in persistently high unemployment. Interest rates remain low for the advanced economies as monetary policy accommodates slow growth and deleveraging. Excess liquidity is created.
Emerging Economies Face Inflation
Emerging economies are not burdened by an excessive debt buildup and are experiencing more robust economic activity (Chart 3). Russia was hit the hardest during the recent recession because a large part of its economy is tied to energy markets, but growth for the four major emerging economies is still projected to outpace that of the advanced economies in 2011.
The excess liquidity in the advanced countries is being directed toward emerging economies as investors take advantage of stronger economic growth and higher returns. This influx of capital is causing inflation concerns to build within the emerging economies. Rising inflation is a by-product of the emerging economies’ reaction to increased capital flows.
These economies have three options when dealing with increased capital inflows. The first option is to do nothing. This would cause currency appreciation, which is not beneficial for the largely export-driven emerging economies. It is clear that these economies are not choosing a "do nothing" tactic because their exchange rates remained relatively stable in 2010 (Chart 4).
The second option is to implement capital controls that prohibit or limit capital flows from abroad. Capital controls historically have not been effective at preventing currency appreciation. They prove easy to circumvent and do not address the source of the imbalanced flows. Thus, emerging markets are forced to take the third option and maintain a stable exchange rate by importing the easy-monetary policy of the advanced economies. To combat fluctuations in the exchange rate, emerging economies are buying foreign exchange reserves and funding these purchases by increasing the monetary base. This is causing high M2 money-supply growth across the emerging economies (Chart 5).
M2 includes the currency in circulation, along with demand deposits and close substitutes for money, such as money market accounts. It captures the excess currency issued by monetary authorities in emerging economies to make foreign exchange reserve purchases. In fourth quarter 2010, annual growth in foreign exchange reserves was 20.8 percent in Brazil, 18.7 percent in China and 6.7 percent in Russia. Emerging economies must adopt this expansionary policy to achieve a stable exchange rate given the capital inflows. However, this lack of monetary independence is allowing inflation to rise.
Commodity Prices Creep Up
Increased capital investment in the emerging economies, coupled with easy monetary policy, is causing commodity prices to rise. As of Jan. 4, annual price increases were 9.9 percent for energy, 18.4 percent for industrial metals, 28.3 percent for precious metals and 35.2 percent for agriculture and livestock (Chart 6).
Some of the increase in food prices can be explained by weather-related supply shocks in 2010. Agriculture production suffered worldwide from severe droughts and floods. However, the four major commodity price indexes are determined in segmented markets. Weather-related shocks cannot explain increases in the other three indexes. The only factors that could cause a simultaneous increase in the four commodity prices are increased global liquidity and demand. These factors are natural by-products of an overly accommodative monetary policy in both advanced and emerging economies.
Implications Are Mixed
Low interest rates are favorable for advanced economies while growth remains modest. Excess liquidity will continue to find its way to emerging economies as long as growth differentials exist. Thus, imminent inflation seemingly threatens the recovery of advanced economies. The potential exists for inflation in emerging economies to spill over into the advanced economies through increased import prices.
However, real exchange rates of the emerging economies, measuring the purchasing power of a currency, will increase with continued high inflation. As prices rise in the emerging economies relative to the U.S., domestic goods will become more attractive. Exports will increase and stimulate the economy. Stronger growth in advanced economies will create a more even distribution of capital investment and tame emerging-economy inflation.
—Adrienne Mack and Scott Davis
About the Authors
Mack is a research analyst and Davis is a research economist in the Research Department of the Federal Reserve Bank of Dallas.