Tapping the expertise of our EM teams: Is inflation a problem? Where it is a problem, what are the main drivers of inflation: food and/or energy prices, or domestic demand? Has the slack in the economy dwindled enough to kindle inflationary pressures? What actions will policy-makers take as part of the tightening process? These are the questions we asked our economics teams in order to understand where inflationary tensions lie and what the likely policy response is.
Is inflation a problem? The EM world appears to be split fairly evenly on this issue. Inflation is already a concern in many AXJ economies, notably in India, where the central bank has raised rates by 150bp in 2010 to ward off inflation. To a lesser extent, other AXJ economies (with the exception of Taiwan, Thailand and Malaysia) are wary of inflation and central banks have moved to take policy rates off the low levels that were in place during the Great Recession. The exception to this rule is Indonesia, where inflation risk is moderate but relatively higher than the rest of the AXJ region. Outside the AXJ region, the economies of Brazil and Peru in Latin America and Poland, Hungary and Romania in the CEEMEA region are grappling with an inflation problem as well.
Our China economics team expects inflation to become the macro focus in 2011 because of cyclical as well as structural factors (see again China Economics: 2011: A Year of Reflation). Cyclically, the lagged effects of ultra-expansionary monetary policy are expected to drive inflation higher. Structurally, the shift in production from the tradable to the non-tradable sector will lower overall productivity, leading to higher inflation. Policy-makers will be keen to push inflation expectations lower, possibly through a combination of some constraints on domestic credit expansion and/or constraints on money growth, some currency appreciation and policy rate hikes.
In other EM economies, inflation is not an immediate problem: In some cases, overall inflation is not high and the metric that matters for policy-makers, core inflation, has remained well behaved (e.g., in Malaysia and Thailand). In other economies like Mexico, Russia and the UAE, the slack in the economy is large enough that the risk of inflation rising sharply seems to be a small one.
Where inflation is a problem, what are its main drivers? Inflation being a concern for policy-makers is a necessary but not a sufficient concern for an aggressive tightening of policy. It is very important to identify the drivers of inflation. Is inflation driven by food or energy or other commodity prices? Or is stronger domestic demand responsible for inflation concerns? If it is the former, policy reaction is likely to be muted. However, central banks will be more likely to take action to quell domestic demand if it is pushing inflation higher.
Food and energy inflation as drivers of inflation: If headline numbers are driven by internationally traded commodity prices, EM central banks are likely to adopt an approach similar to the one they had in 2007. Then, EM central banks resisted tightening as international commodity prices were driven by strong global demand and central banks were individually incapable of lowering international prices through tighter monetary policy. Clearly, collective action would have helped, but the difficulties of creating such a like-minded group and the difficulties of sustaining commitment in this monetary policy cartel would have proved formidable - and this when growth was exceptionally strong globally without a strong hint of the oncoming global recession. Today, a similar consensus appears to exist among EM central bankers, but for very different reasons. EM economies now appear to be growing sustainably, providing a bid for food, energy and other commodity prices. At the same time, ultra-loose monetary policies from the major central banks have pumped enough liquidity into the system to drive up asset and commodity prices. Getting EM central banks to collectively hike rates by enough to offset liquidity injections from the major central banks appears to be close to impossible, given that this would almost certainly put domestic growth in the EM economies in question at risk.
And indeed, food inflation appears to be the main driver (or the joint main driver) of inflation in a large number of EM economies. The big risk, naturally, is one of second-round effects of food price inflation on core inflation. This is particularly true where food inflation is high, domestic demand is strong but domestic demand-led core inflation has not yet picked up. The ideal example in this category is Indonesia, where food inflation has been a problem for a while and where domestic demand has been strong as well. The risk of a pass-through from food to more general inflation is therefore a worry. Turkey shares similar concerns but food prices are expected to normalise there, cutting down the risk of a pass-through into more general inflation.
Domestic demand-led inflation: In a handful of economies (Brazil, Indonesia, Israel, South Africa and Saudi Arabia), however, domestic demand-led inflation is the most important concern (though Israel really has only a housing price inflation worry). Of these economies, Indonesia has been pointed out as the economy that has moderate risk both from domestic demand pressures as well as the risk of pass-through from food prices to overall inflation. Brazil and Israel have both used rate hikes so far, partly to address inflation concerns. Both central banks are expected to further raise policy rates in order to bring inflation under control as needed.
Is slack so little now that inflation is likely to be a problem in the near future? A surprisingly large number of economies report that economic slack is still present, but that the output gap is not very wide.
In some economies, the output gap is closed, indicating that a continuation of rapid growth may start putting upward pressure on inflation going forward. In some cases, the output gap is still negative and quite large. Prominent in this category is the Russian economy, where the output gap has narrowed but still remains quite large. It is not surprising, then, to note that Russian policy-makers appear to be giving much more support to pro-growth policies than to anti-inflation ones. The South African economy is the other economy where the output gap is large enough for policy-makers to ignore inflation concerns for the moment. Two rate cuts of 50bp each recently delivered by the SARB provide strong evidence of this.
What is the policy response likely to be? In light of the above, it may appear somewhat surprising, at first blush, to note that monetary tightening seems to be almost universal in the EM universe that we cover. However, monetary tightening becomes easier to understand when we differentiate between normalisation of rates and moving to an outright restrictive monetary policy stance. Many of the policy rate hikes, particularly in the case where the output gap is still negative and inflation is not a problem, represent normalisation of policy to a stance that is a little less expansionary. Even in the economies where inflation is a problem and the output gap has either closed or is very narrow, we don't expect policy rates to be hiked to an extent where they will begin to hurt growth. Even for the outperforming AXJ economies, policy tightening is likely to be calibrated to just keep growth from rising further rather than pushing it lower. Policy actions are thus unlikely to derail growth in the EM economies.
Constrained by the trilemma: Even if monetary policy-makers wanted to be aggressive, they would be bound by the constraints of the trilemma (monetary policy-makers can achieve only two out of the trinity of unconstrained capital flows, a stable exchange rate and independent monetary policy).
At a time when capital inflows into EM economies have been aggravated by the Fed's QE2 salvo, avoiding currency appreciation will severely limit the amount of monetary tightening central banks can attempt. Of course, central banks may choose to break the flow of capital into the domestic economy through the use of capital controls, but to do that, they would have to rival the extensive controls that China has in place. In our view, the kind of capital controls we have seen so far (taxes on capital inflows into domestic fixed income markets) are more likely to change the composition of inflows towards equity flows, but not change the overall level of capital inflows.
Which monetary policy tools? Contrary to their developed market peers, EM central bankers are not reluctant to use the many tools at their disposal, including policy rates, the exchange rate, liquidity constraints, capital controls and even strong moral suasion to banks regarding lending activities. Focusing on a narrow set of tools, however, interest rates and exchange rates appear to be heading higher going forward, except for India, Thailand, Hungary and Brazil, where there appears to be limited scope for further currency appreciation. In many cases, policy-makers may prefer to have less currency appreciation but may not be successful in warding off capital inflows and the resulting upward pressure on their currency. In any event, EM economies appear to be set for a gradual appreciation of their currencies, probably thanks to a combination of tighter monetary policy and steady capital inflows in line with the constraints of the trilemma.
In summary: The policy response to inflation in overheating economies is likely to lead to a salutary slowdown in these economies rather than a hard landing. Where inflation is not a problem, policy rates may be hiked, but this will likely be more for the purposes of normalisation of policy rates than for creating a restrictive monetary policy stance. If successful, these dual strategies should allow solid growth to persist in the EM world. The key risk remains that the combination of relatively easy domestic monetary policy in EM countries and even more easy money imported from the leading economies will push inflation higher. The policy response then would have to be stronger if EM central banks wish to protect medium-term growth by keeping inflation under control.
A close call, with odds tilted towards a rate hike on Monday. We think the November NBH meeting will be an interesting one, and the odds of a 25bp rate increase are better than even. Within the context of QE elsewhere and a still rather uncertain macro outlook, this is a call that needs some explaining. In this short piece we go through the main rationale for our call, and the risks around it.
Inflation likely to be seen above target, again. The Inflation Report is a very important input into the NBH's deliberations. Back in August, the NBH revised up its CPI forecast to above target, but refrained from hiking rates due to, among other things, its wait-and-see stance on the government's fiscal policy decisions. Given that the fiscal uncertainty has been lifted, and the NBH has already commented (negatively) on the measures, this argument will not hold water this time. Also, we note that several senior MPC members have sounded rather hawkish lately.
So, what will the new forecast look like? Note that we start from a higher inflation rate than the previous report assumed, so there is already a ‘carryover' effect worth around 0.4-0.5%. We think that the external assumptions will change: a stronger HUF (both versus EUR and especially versus USD) and higher oil prices (and, most likely, food prices). On the HUF side, a 3.5% appreciation versus EUR (and even larger in NEER terms) should shave off around 0.5% from inflation in 2011-12. The higher international oil price assumption (as well as food) should add around 0.3pp, we think. And according to NBH sources, the recent fiscal policy decisions would add around 0.3% to inflation in 2011 (assuming full pass-through, more like 1%). Overall, given an August forecast of 3.5% in 2011 and 3.4% in 2012, we think that net-net the new forecast should not deviate greatly from the previous one, other than maybe having more of a ‘hump' in 2011: in other words, CPI should still be seen above target in the projection.
Market jitters will also put pressure on the central bank. As we always say, the NBH's reaction function does not rest on the ‘inflation targeting' pillar alone. The bank is also very sensitive to the risk environment: the more unstable it is, the more cautious the monetary stance the NBH deems appropriate. If we look at the widening in CDS spreads and bond yields since the October meeting, it is pretty clear that the news has not been good. Moreover, Hungary seems to have worsened by more than its peers (Bulgaria, Romania), judging from recent market action. For the NBH, both absolute and relative gauges of risk matter.
Reasons to hold? While the new inflation outlook should show CPI still above target, we note that core pressures are still rather muted. The doves on the NBH will point to core inflation running still well below target (1.8%Y in September, and actually flat in 3m/3m terms on our ‘clean core' measure). In addition, inflation in some demand-sensitive components (say, market services) continues to ease on a trend basis, which is encouraging in terms of expectations. Therefore, the doves will argue that when core CPI is muted, and inflationary pressures are mostly generated by fiscal policy and external factors, the central bank should not raise interest rates. Also, another reason not to raise rates could be that the risk environment could change quite quickly again, making the rate increase look rather odd ex-post. And finally, the NBH could choose to wait to see more details on possible structural adjustments to the budget, to be announced in 2011.
Bottom line: we think the NBH will hike by 25bp. This will be a close call, and both options have their merits. Already three weeks ago, back from Budapest, we argued that rate hikes were far more likely than the market perceived (see Hungary: Getting Away with it, for Now, November 1, 2010). The meeting on Monday will be interesting, and probably yield a close outcome, but on balance we think that it will be hard for the NBH to show once again inflation above target and not raise interest rates. The bank's mandate is in terms of headline, not core inflation. If we are right on this out-of-consensus call (+25bp, to 5.50%), we still do not think that this will usher in a series of rate hikes. This move would be best understood as the NBH seeking to establish its inflation-targeting credibility (as well as reacting to loose fiscal policy). Hungary does not have a severe inflation problem that calls for regular tightening, so we think that a quarterly pace (to coincide with Inflation Report publications) would make most sense. Bigger or faster rate increases would become necessary only if HUF sold off dramatically in a very risk-averse environment - but we are not there yet.
Despite a sharp rebound in Mexico's economy this year, investment spending has dramatically lagged. At first glance, it appears that Mexico is experiencing a capital expenditure strike. After all, even as GDP posted a solid 5.3% annual gain in 3Q with manufacturing production expanding and industrial exports soaring to record levels, spending on new machinery and equipment remains at deeply depressed levels. Indeed, it seems to be different this time: whether we look at the 2001 recession or the string of nearly uninterrupted growth between 2003 and early 2008, exports and equipment outlays moved closely together. Today, by contrast, industrial exports have sky-rocketed - thanks in part to Mexico's sizeable share gains in the US imports' market - while capital outlays are barely above the cycle lows reached in 2Q09.
Don't Blame Industry
But before you blame Mexico's captains of industry for being overly cautious, Mexico's investment strike appears to reflect a weak consumption dynamic. It may seem odd at first to blame weak domestic drivers for limited investment spending. After all, Mexico's most dynamic manufacturing sectors are export-driven. The automotive industry for example - which directly accounts for over 15% of total manufacturing - exported 83% of all units made between January and October this year. But while export-focused sectors have been the most dynamic, the weight of domestic-focused manufacturing still dominates industrial production. Even with exports running at record levels, sluggish growth in domestic-focused manufacturing has meant that overall capacity utilization remains well below historical averages - that, in turn, explains much of the weak rebound in investment. Put simply, investment spending has not rebounded more sharply because Mexico still suffers from excess capacity. And but for the sharp rebound in export-demand for Mexico's manufactured goods, Mexico would have faced even greater levels of excess capacity.
While the turnaround in Mexico's manufacturing output has been impressive, aggregate figures mask sharp differences between various sectors. Since bottoming in June 2009, manufacturing production expanded at a 12% annualized pace through September, according to our calculations; over the same period, industrial exports soared at a clip in excess of 30% annualized (see "Mexico: The Industrial Fiesta", This Week in Latin America, January 20, 2010). Not surprisingly, export-oriented sectors - such as automobiles, electronics and machinery - which had been the hardest hit, rebounded the sharpest. In contrast, domestic-centric sectors experienced a modest downturn, followed by a very sluggish recovery. While no Mexico watcher should have expected that defensive sectors like food and beverages would have displayed the severe swings that highly cyclical areas like machinery or transportation equipment did during last year's slump, it is worth highlighting that the recovery in the former has been anemic at best.
Capacity utilization has also shown a tangible divergence between external and domestic-oriented sectors. Based on our calculations, seasonally adjusted capacity utilization for industries that focus primarily on the domestic market was still about two points below the pre-crisis average. By contrast, the level of capacity utilization for rapidly recovering export industries stood less than one point from the average prior to September 2008. With the trend in consumption poised to remain sluggish, available slack in domestic-focused sectors should keep investment spending levels from returning to the pre-crisis norm of over 11% annual growth.
A caveat in our analysis is that there is probably more overlap between domestic- and external-focused sectors than the available data allow us to determine. And rather than buying new equipment more aggressively, it is possible that factories may continue to rely primarily on adding workers and expanded hours to meet rising demand as they have so far this cycle (see "Mexico: More than Just Cyclical?" This Week in Latin America, June 14, 2010).
The case for a robust rebound in equipment outlays depends on a more substantial recovery in consumption, in our view. Unfortunately, we suspect that Mexico's two-tiered economic recovery is likely to persist as the hand-off from the ongoing external-led rebound into domestic strength continues moving forward at only a gradual pace. Indeed, it should come as no surprise that Mexico's recovery has been more muted and consumption more subdued than in the rest of the region: after all, Mexico has seen its terms of trade deteriorate during the course of 2010, in sharp contrast with the experience in the rest of Latin America (see "Mexico: Squeezed from Abroad", This Week in Latin America, November 8, 2010). With modest consumption gains, we expect the sluggish recovery in domestic-focused manufacturing to continue to limit the need for investment spending.
An improvement in job creation and, with it, an upturn in credit to consumers can provide additional support to consumption in 2011. As our Latin American banks analysts Jorge Kuri and Jorge Chirino have argued, Mexico may be at a turning point in its credit recovery cycle which, according to their work, tends to lag by six months the rebound in economic activity (see Grupo Financiero Banorte: Buy the Turnaround, October 18, 2010). In 3Q10, real bank credit to consumers rose at a modest 3% seasonally adjusted annualized clip, following a two-year slump that led to a contraction of almost 30%, according to our calculations. But we remain cautious: despite the strong pick-up in job creation since 2009, the strongest pace of hiring has taken place in informal jobs (see "Mexico: Where Have the Good Jobs Gone?" This Week in Latin America, August 30, 2010). The quality of job creation only began to show some modest improvement in 3Q10, coinciding with a meaningful deceleration in the pace of job growth. That in turn, could limit the pace of credit recovery going forward. And given our still cautious view on the nature of the recovery in the US during 2011, we see little upside risk to our already above-consensus forecast of 3.9% GDP growth for next year.
Bottom Line
Mexico's rebound in 2010 has been sharper than many expected and much closer to our more upbeat view of the magnitude of the recovery. But while we have been positive on the magnitude of the recovery, the quality of the recovery continues to disappoint. Mexico's economy remains two-tiered and the handoff from export-led growth to domestic growth remains modest. That explains in large part the increasingly dovish comments from Mexico's central bank: a dovish tone that could be more pronounced in this week's final communiqué of the year. After all, monetary authorities are closely watching the force of domestic demand - not simply headline GDP - to gauge whether to keep interest rates unchanged or consider easing. Until Mexico shows stronger signs of domestic consumption rebounding, Mexico is likely to remain at the mercy of US-driven growth, with all the risks that entails.
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