Negative Real Interest Rates ‘Round the World Bode Ill for Inflation

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While some writers in the US have taken note of the fact that the Fed’s rate cuts have propelled the US into negative real interest rate territory, until recently, the role of overly-permissive monetary policy in inflation-fraught countries like China and the Gulf States has gotten comparatively little attention. Last week, the Economist devoted an article to it:

Indeed, official figures understate inflationary pressures in many emerging economies. Widespread government subsidies and price controls are one reason, and price indices are often skewed by a lack of data or government cheating. China’s true inflation rate may be higher because the consumer-price index does not properly cover private services. Delays in data collection in India can mean big revisions to inflation: the final number for early March was almost two percentage points higher than the original. The latest wholesale-price inflation rate might therefore be pushed up to 9-10%. If measured correctly, five of the ten biggest emerging economies could have inflation rates of 10% or more by mid-summer. Two-thirds of the world’s population may then be struggling with double-digit inflation….

Many policymakers in emerging economies argue that serious monetary tightening is not warranted: higher inflation, they say, is due solely to spikes in food and energy prices, caused by temporary supply shocks and speculation. Higher interest rates cannot call forth more pigs or grain.

What is worrisome is how this trend is being depicted within those countries. The US, which clearly has not kept its financial house in order, is at risk of being scapegoated. From Xinhua:

The U.S. Federal Reserve’s interest rate cuts have helped increase liquidity, but have also led to rising prices in commodities, Zhou Xiaochuan, governor of the People’s Bank of China, said on Friday.

The central bank governor said this has affected the anti-inflation policies of emerging markets.

Zhou was speaking at a conference following the release of a report by the Commission on Growth and Development, an international organization that focuses on policy consultation in emerging markets, and provides reference for aid programs.

“The U.S. Fed has significantly reduced interest rates on the other hand, global commodity market prices have risen. A lot of developing countries are now suffering from rising inflation,” Zhou said.

The central banks of the world should cooperate more closely to tackle the inflation problem, he said.

This may not be quite as disingenuous as it seems. If China raises interest rates to choke off inflation, it will attract “hot money” currency inflows, which are stimulative and will undermine the effect of rate hikes. Thus, the only way out of this box may be coordinated interest rate increases, but even those may not be sufficient to stem a capital influx into China.

A couple of stories give a more visceral sense of how deep and extensive the inflation problem is, and how messy the way out is likely to be. First,Ambrose Evans-Pritchard in the Telegraph showcases the Argentine approach:

Argentina is defaulting on its sovereign debt yet again, this time by stealth…

It seems like only yesterday that Argentina halted payments on $95bn of external debt. The “Great Haircut” of 2001 was the biggest default in history. Investors are so forgiving.

Argentina’s trick this time, under the presidential double act of Nestor and Cristina Kirchner, has been to purge the National Statistics Office and appoint a friend to manage inflation data.

The official Consumer Price Index (CPI) is 8.9pc. This is the benchmark used to set payments on inflation-linked bonds, now 40pc of the country’s debt.

The true inflation rate is more than 25pc, according to union staff of the statistics office. They allege manipulation. St Luis province is issuing its own data, three times higher.

“Argentina is engineering a partial default on its domestic debt,” said Professor Carmen Reinhart, from Maryland University.

Some $300bn of inflation-linked bonds from Turkey, Hungary, Poland, Mexico, Brazil, South Africa, and other emerging markets (EM) have been sold, mostly to pension funds…

On paper, Argentina looks safe. The world’s biggest exporter of soybeans – and number two in corn – is riding the food boom, even if at war with its own farmers. The trade surplus is $12bn. Foreign reserves are more than $50bn. Yet the default premium is soaring anyway.

Argentina is a warning of what can go wrong once inflation gets out of hand, as it has in roughly half the world.

Among the CPI rates – if you believe them – are: Ukraine (30pc), Venezuela (29pc), Vietnam (25pc), Kazakhstan (19pc), Latvia (18pc), Qatar (17pc), Pakistan (17pc), Egypt (16pc), Bulgaria (15pc), Russia (14pc), the Emirates (11pc), Estonia (11pc), Turkey (9.7), Indonesia (9pc), Saudi Arabia (9.6pc), Romania (8.6pc), China (8.5pc) and India (7.6pc).

The International Monetary Fund says 70pc of the EM inflation shock came from soaring food costs last year (typically 40pc of the basket, versus 12pc for richer states). But the home-grown part is fast gaining a life of its own.

“Easy money is the culprit,” says Joachim Fels, chief economist at Morgan Stanley.

“Weighted global interest rates are 4.3pc, while global inflation is above 5pc. The real policy rate in the world is negative. Central banks are both fuelling and accommodating the rise in food and energy prices,” he said.

Fixed exchange rates are playing havoc. Most Gulf states are pegged to the dollar, while China runs a crawling peg. These countries are importing the emergency stimulus of the US Federal Reserve when they least need it….

Professor Reinhart warns that investors may have jumped from the frying pan into the fire. The risks have been displaced from an external debt crisis to an internal crisis of the kind seen time and again over the history of free capital flows…

“Governments that have repeatedly inflated away or defaulted on their debts will, in all likelihood, not hesitate to default again,” she said.

Never buy a bond until you know who runs the statistics office.

A Bloomberg story focuses on inflation and monetary policy in China and emerging markets:

Central banks from Beijing to Bangkok are losing their bets that a global slowdown would temper price increases…

The result: In China, Thailand, the Philippines and at least eight other Asian economies, benchmark borrowing costs are lower than the rate of inflation, resulting in negative real interest rates, according to data compiled by Bloomberg. The risk is that prices will spiral even faster, leading to overheated economies and an eventual bust.

“Unless there are concrete measures to tackle inflation, investors are going to reconsider the Asian growth story and realize it’s not as rosy as it seems,” says Sailesh Jha, an economist with Barclays Plc in Singapore. “Confidence will weaken, and there’ll be a significant correction in asset prices such as stocks as capital flows out.”

Thailand’s central bank has held its main rate at 3.25 percent for almost a year, while inflation has tripled to 6.2 percent. The People’s Bank of China, which announced in early December a planned shift to a “tight” monetary policy, has kept its main lending rate unchanged at 7.47 percent since the end of 2007, even as inflation soared to 8.5 percent, near a 12- year high….

Without stronger action by the central bank, “the eventual correction will come at a much higher price,” says Kevin Lai, senior economist with Daiwa Research Institute in Hong Kong. “The more the problems get delayed, the greater the risk. The subsequent bust cycle will be long and painful.”…

“Policy makers were expecting slower global growth to bring down inflation and do their work for them,” says Robert Prior Wandesforde, a senior economist at HSBC Holdings Plc in Singapore. “That’s not going to happen. Monetary policy is incredibly loose, and they have a lot of catching up to do.”…

Asia’s economies aren’t the only ones falling behind. “Globally, short-term interest-rate changes set by central banks have not increased on average by as much as inflation,” John Taylor, a Stanford University economist and author of a monetary-policy formula often cited as a benchmark, said in a Tokyo speech May 28. “This is counter to key monetary principles.”….

The spiraling prices threaten the credit ratings of emerging-market nations, Fitch Ratings said in a report May 27. Russia is the most vulnerable of the so-called BRIC economies, which also include Brazil, China and India; in Asia, Vietnam and Sri Lanka are among the top 10 at risk, according to the report.

When I was young, a country with a high inflation rate was considered to be a bad place to put your money, since the high interest rate would be offset by erosion of its value in real terms. While we are a long way away from that viewpoint returning, we may see a lot of upheaval in currency values as investors try to get a handle on real (versus published) inflation rates and likely official responses.

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  1. Richard Kline

    I can only strongly concur that coordinated macro-monetary policies are desperately needed. China’s determination to keep its currency low and the Fed’s unilateral plunge to severely low rates—2% where real inflation is likely closer to 7% than the reported 3.9%—are both profoundly destabilizing acts for the global financial system.

    Time was, one function of the lamentable IMF and World Bank was to enforce a certain uniformity of action upon most large economies engaged in international trade. Of course their system was rigged to embed large American advantages, which were themselves in place due to the disproportionate size of the US economy and capital markets. Now, the US is a much smaller share of the global financial system, and emerging players have suffered so many negative consequences due to malfeasant and frankly incompetent, ideologically motivated IMF and World Bank destruction that ‘non-cooperation’ has become the norm. Well, we see where this is getting us all, now: everybody’s phonying their numbers to boost headline growth at the expense of the capital markets, which in turn act with reckless disregard for the consequences of their actions as well.

    Interesting times, indeed . . . . Like it or not, and clearly no high level policy maker or plutocratic speculator likes it, we are all so interlinked that effectively we are in this thing together, either mutual aid or mutually assured impoverishment: One World, Love It or Leave It.

  2. Scott Finch

    i was reminded of an interesting paper titled “The Forgotten History of Domestic Debt”. It may be found at under working papers.

  3. Scott

    How about Japan’s easy money policy? That country has had absurdly low interest rates for a very long time as a result of BoJ attempts to reflate Japan’s growth. That has to have contributed to this problem…the “carry trade” has certainly been a source of investment excesses.

  4. Lune

    I’m not a financial sector expert, but could anyone explain why China shouldn’t impose capital controls to reduce speculation and short-term currency inflows? Exactly what would the downside to a regulated and closed exchange regime be? And is that downside more than the downsides of the current system?

  5. steelhead

    Geez, you all talk like inflation is bad or something. Come on folks, if we get inflation cranking real good we could pay that $10 Trillion federal debt they’ve run up with a boatful of hard red winter wheat and Microsoft software.

    In the event you don’t get it, by setting the overnight target rate well below the inflation rate, the Federal Reserve Bank is out to debase the dollar – big time. And its working. But, not to worry. Global financial collapse will solve this problem – in about 5 years. Between now and then, good luck holding onto your money.

  6. PrintFaster

    Thanks for the pointer on the paper. The abstract has a very trenchant point:
    “Second, the data go a long ways toward explaining the puzzle of why countries so often default on their external debts at seemingly low debt thresholds.”

    What they are saying is that the US will default on Chinese and Japanese debt.

    Good luck to them if they think that they can collect anything on US sovreign debt.

  7. Francois

    Is it just me who think a legion of Paul Volcker clones spread into the central banks of the world could help?

    Sort of “Attack Of The Clones” Financial Edition


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