Fed taper could spark inflation

Tapering by the Federal Reserve of its five-year quantitative easing (QE) policy risks flaring up inflation in emerging markets if it is not done carefully, policymakers and analysts have warned.

The availability of cheap money due to QE may have fuelled inflation in some countries by stimulating demand, South African Finance Minister Pravin Gordhan told Emerging Markets.

He said that strong flows into many emerging economies led to the appreciation of their currencies and probably helped reduce inflationary pressures. “This may have negated some pressures coming from increased demand,” he said.

However he stressed that this was not the case in South Africa, where inflows of hot money had not been enough to push inflation above its target.

Gordhan said talk of Fed tapering of its asset purchase programme over the summer had reversed the exchange rate movements, which was likely to increase imported inflation in many emerging markets.

“The size of the impact depends on how the Fed manages its exit,” Gordhan said. “Sudden exit, which seems unlikely, will have strong inflationary impact, while at the same time reducing demand.”

Zhou Xiaochuan, People’s Bank of China Governor, told Emerging Markets that “in theory, quantitative easing inevitably affects global price levels, and abundant liquidity may ultimately translate into inflation.

“It merits attention that the global inflation trend could lead to unexpected developments or abrupt hikes in inflation in various countries, which in turn will make macroeconomic management more difficult and increase economic risks.”

Enrique Iglesias, secretary general of the Ibero-American Cooperation Secretariat, said there was a danger of inflation picking up and the severity of the problem depends very much on the way governments tackle it.

“What I see is that there is an awareness like never before that inflation is an issue that we need to watch,” he said. “This is an important change. There is a fear of falling into the inflation trap, and this is very good.” Iglesias added that the main responses to the dangers of inflation should be “solid fiscal policy” and “intelligent monetary policies”.

Among countries most at risk of inflation, Brazil attracts cautious glances. Felipe Hernandez, an analyst with Morgan Stanley, said that although it was not the bank’s base case scenario, the country was vulnerable to “potential negative surprises on inflation in the short term, that could force tighter-than-expected monetary policy”.

For Turkey, Deutsche Bank chief economist Robert Burgess said he saw underlying inflationary pressures building up, as well as Indonesia and India whose exchange rates depreciated sharply during the summer, were also seen at risk.

IMF Western Hemisphere director Alejandro Werner said that Latin American countries had generally been able to handle capital market shocks through their inflation-targeting regimes. “The pass-through from exchange rate to inflation has significantly diminished in inflation targeting countries,” he told Emerging Markets.

The “normalization of monetary policy” will “take a lot of time” and will generate challenging times for central banks, Werner said, but added that he was optimistic that markets were not very vulnerable to shocks.