EM central banks are doing Fed’s dirty work

By Richard Bernstein

US investors are increasingly fearful of inflation. Every cycle has some growth in headline inflation, but there is a big difference between such normal, cyclical pricing pressure and the rising fear that the US economy is somehow mutating into that of a developing markets country.

Ironically, emerging market central banks’ recent monetary tightening is likely to prevent US inflation from getting out of control and could actually prolong the US economic cycle.

“Printing money” is today’s derogatory description of what was once simply called “monetary stimulus”. Some observers, distorting basic monetary theory, argue that monetary stimulus itself causes inflation. In fact, it is only the combustible combination of printing money and creating credit that stokes inflationary fires. With credit growth in the US still moribund, its M2 growth is currently less than 5 per cent.

Monetary theory states that an economy cannot sustain an abnormally high inflation rate without abnormally high credit growth that stimulates abnormal demand. Consider the recent housing bubble.

Abnormal growth in housing-related credit caused abnormal demand for housing, which in turn caused abnormal inflation in home prices. The US might experience some normal, cyclical pricing pressures (indeed, the trough in the headline US consumer price index occurred nearly two years ago), but sustained above-normal inflation seems unlikely unless credit growth begins to expand rapidly to stimulate demand beyond available supply.

It is easy to blame the Federal Reserve for the recent increase in US inflation, but analysis suggests that investors may be faulting the wrong central bank. Whether they realise it or not, US investors’ current inflation fears are more closely related to emerging markets’ loose monetary policies and resulting strong local-market credit growth than to the Fed’s policies and US domestic credit growth.

Abnormal credit and money-supply growth in the major emerging markets have been spurring abnormal inflation exactly as monetary theory would suggest. Monetary growth during the past 12 months in Brazil, Russia, India and China now ranges between 15 per cent and 30 per cent. These are the highest monetary growth rates among the major economies. Very loose credit conditions have boosted excess demand, which has led to significant and rising rates of inflation. In fact, the Bric countries now have among the world’s highest inflation rates. Consistent with theory, high rates of credit growth have overstimulated demand, which has led to high rates of inflation.

Emerging market central banks have been tightening monetary policy to curtail credit growth and slow aggregate demand. If they are successful, the recent uptrend in commodity prices might end. It has been widely accepted that the incremental demand for commodities during the past decade has come from the emerging markets. That incremental demand has been fuelled in part by the easy money and credit conditions noted. However, it might be a mistake to extrapolate from past demand trends, especially in light of emerging market central banks’ increasingly tight policies.

Yield curves are very good forecasters of future economic and profits growth. Whereas the US yield curve remains very steep (with higher interest rates over longer maturities), suggesting robust growth, yield curves in many parts of the world are demonstrably flattening as their central banks’ tightening policies take hold.

India, for example, has one of the world’s flattest yield curves, with the spread between one- and 10-year interest rates now only about 35 basis points. A year ago, that spread was over 250bp. By our estimates, India’s curve might invert over the next several months. Historically, inverted yield curves have consistently signalled significant economic slowdown, if not outright recession.

The emerging markets are increasingly showing characteristics of late cycle economies: inflation ramping up, monetary tightening, yield curves flattening and overly optimistic earnings forecasts (with 45 per cent of emerging market companies reporting negative earnings surprises during the last reporting period).

The US economy, on the other hand, continues to demonstrate early- and mid-cycle traits. For example, growth in US industrial production is now positive in 30 of the 32 industrial categories measured by the Fed.

It appears that the US economic recovery is slowly turning into a broad-based expansion, but instead of welcoming this improvement, investors are growing wary that the Fed will soon embark on a policy of monetary tightening.

If emerging market central banks ultimately succeed in curbing local credit growth and cooling their economies, then the commodity inflation in the US that presently scares so many investors will probably subside. Emerging market central banks are effectively doing the Fed’s dirty work and US assets might be the biggest beneficiaries.