And why it’s unlikely to change course and so it’s up to us to cope.
It was a study in contrasts. On Tuesday, the Reserve Bank of India raised the repo and reverse repo rates by a quarter percentage point each, citing concerns on inflation. A day later, its US counterpart’s Federal Open Market Committee or FOMC said after its first meeting this year that it foresaw “exceptionally low levels for the federal funds rate for an extended period”.
The growing worry in developing countries is that the two scenarios are linked, that the Fed’s actions are forcing the hand of their central banks, by contributing to runaway inflation in their economies.
FOMC said after its two-day meeting, ended yesterday, that it planned to continue the Quantitative Easing campaign announced last November, popularly termed QE2. This injection of money is driving inflation in developing countries like India and China, says John Praveen, managing director of Prudential International Investments Advisers.
Praveen notes that quantitative easing policies impact inflation through several channels: “Stronger GDP growth, which is pushing up commodity prices and thereby fuelling inflation; and through foreign fund inflows, which has a dual impact in a country like India — it fuels GDP growth and also leads to asset price inflation, which in turn contributes to GDP growth through the wealth effect.”
David Malpass, who was Bear Stearns’ chief economist and is now president of Encima Global, an economic research and consulting firm, says there has been a fundamental change in the US Federal Reserve’s approach to monetary policy since the meltdown of 2008. That has multiplied the impact of a loose US monetary policy on inflation abroad.
“Clearly, US monetary policy is causing food price inflation in India and China,” said Malpass, answering a question from Business Standard at the Dow Jones Indexes 2011 Economic Outlook. “By changing fundamentally how we do monetary policy, meaning this unprecedented Fed ownership of long-term bonds, which has never happened – that gives people an expectational push into things like gold but also a range of commodities...and so that adds to the normal reasons why a loose US monetary policy causes food inflation abroad.”
Other priority
However, the US Fed has a dual mandate – to ensure maximum employment and price stability. As FOMC’s statement noted yesterday, the ongoing economic recovery in the US has been “insufficient to bring about a significant improvement in labour market conditions” and “measures of underlying inflation have been trending downward”.
Given these conditions of low inflation and high unemployment, few analysts expect the Fed to change course in the near term. Nor should it, says Ethan Harris, head of developed economics research at Bank of America-Merrill Lynch. “If the Fed didn’t do super-easy policy, the US economy would be in a lot worse shape. Now would that solve the problems of the world, to just let the US economy collapse? I don’t think so. It would make other assets even more attractive than US assets because you’ve got a collapsing economy.”
But critics of the Fed complain that its loose monetary policy is helping neither the US nor the rest of the world. Malpass recalls he was critical of the Fed’s “super low interest rate policy” during 2004-2006. “It didn’t stimulate good growth in the US. It caused commodity prices to go up around the world, so in many ways it was an Asia stimulus policy. And, it caused the housing bubble. There was just too much money,” argues Malpass, adding, “I think we would have grown faster if the Fed had moved us to a more normalised monetary policy in 2009, with a Fed funds rate of 0.5 or 1 per cent…and I think it’s the same now.”
Harris says the Fed’s objective with QE2 was to stimulate the economy by getting investors to switch out of fixed income assets into the stock market, but the central bank “can’t pick and choose which asset class to push people into, so the unfortunate side effect of the super-easy monetary policy is probably to put some pressure on commodity prices”.
Home focus
But if that “unfortunate side effect” is contributing to inflation in countries like India, can or will the Fed do anything about it? Not really. As Praveen says: “Central banks like the US Fed are driven purely by domestic considerations. Hence, while the Fed may be aware of the inflation concerns in developing countries and may be also aware that the Fed’s domestic policies could be indirectly contributing to inflation problems in developing countries, the Fed is NOT going to change its policy course until its domestic policy objectives — reducing unemployment and stabilising inflation — are met.”
However, even if higher inflation and monetary tightening could lead to a pause in fund inflows into India in the very short term, analysts are bullish on emerging markets and on India for this year. Michael Woolfolk, managing director, global markets division, at The Bank of New York Mellon, expects India to grow between 8 per cent and 10 per cent this year, even as he predicts inflationary risks will lead to tighter monetary policies.
Prudential forecasts an acceleration in India’s GDP growth, from eight per cent to nine per cent, and expects emerging markets to post 20 per cent gains, as against 15 per cent for the US and around 12 per cent for Europe.
Meanwhile, even as FOMC noted the “subdued inflation trends” in the US, RBI sharply raised its domestic inflation forecast from 5.5 per cent to 7 per cent.
