THE POLICY CHALLENGE
The extent to which emerging market economies can alter policy to help offset the impact of declining activity in the industrial world remains unclear.
One view is that if weakness in the industrial world threatened to negatively impact emerging economies, their strengthened fundamentals, their recent history of improved macroeconomic and financial policies, along with the vastly increased reserve holdings of many of those countries, would permit an expansion of domestic demand to help offset a slowdown in exports. To the extent that the threat of inflation may now be moderating as a result of declining food and commodity prices and in reflection of the slowdown in much of the global economy, the scope for stimulative policies in some of the emerging economies may be increasing.
However, questions remain about the capacity of some emerging market economies to respond effectively to such developments as the experience in those countries with such policies is limited and mostly untested.
There are additional considerations that need to be taken into account. First, and increasingly obvious as one looks across the multitude of countries now categorized as “emerging” economies, are the marked differences within this group. There are crude-oil exporters and importers; there are exporters of other commodities, including food, and there are importers; there are countries with exceptionally high savings rates and those with more traditional, or even low, rates of saving. Partly reflecting these differences, there are surplus countries and deficit countries; there are countries that are primarily agricultural and/or commodity producers and countries with highly sophisticated manufacturing sectors – and everything in between. And these are only the economic differences. Social, political and other differences abound. In short, it is increasingly difficult to generalize across the emerging world. Volatility in the price of crude oil, as just one example, has sharply differing effects across the emerging market countries, with very different implications for policy.
Second, in light of these differences, a softening of activity in the industrial world will have very different effects across emerging countries. Only after those effects can be identified for each individual country can questions be posed about the appropriate policy response in each. There are also major differences in the capacities of these countries to design and implement those policies.
Nevertheless, at the present juncture, and even with the recent easing of food and commodity prices, there remains a critical policy challenge confronting virtually all of the emerging market economies – and, indeed, all countries of the world: the threat of inflation.
And that threat changes everything as far as policy options go. In many countries, the stimulus to inflation is not solely from classic excess demand across the economy; it originates to a significant extent in the increased prices of commodities, including crude oil, and the prices of many food items.
An increase in commodity and food prices should be a situation that calls for a one-off pass-through of those price increases to the final products that they affect. One could conduct a thought-experiment wherein the impact of, say, a rise in crude-oil prices is reflected overnight in the prices of all products into which crude oil and its derivative products are either direct or indirect inputs. If this could be engineered, the inflation threat could disappear. But this is not how markets work and the pass-through takes time, creating inflationary expectations.
Moreover, even if a one-off price level adjustment could be engineered, it would not be accepted by many segments of society. While the direct price increases on petroleum products represent a wealth transfer from the crude-oil-using population to the oil producers, those transfers will be resisted and wage demands will increase, spreading the inflation more broadly across the economy and generating expectations of further price increases. Similarly with food price increases.
Beyond this, there is the balance of payments impact of the shift in the terms of trade to be dealt with. In the end, what starts out as an economic issue quickly becomes a political issue – as is increasingly evident in many oil-and-food importing countries. The required wealth transfer is simply not accepted – and is increasingly resented – by the populations. This resentment has already been seen in the demonstrations mounted by consumers, truckers, fishermen, and others in many countries.
Dealing with this inflationary reality will require a differentiated approach across the world. In some emerging market countries, the commodity and food-price increases are over-laid on already overheated economies and relatively well understood, and classic policy actions are needed to deal with the situation. However, in other parts of the emerging world, the inflationary pressures are rising in an atmosphere of weakening growth and activity.
This presents particularly difficult choices to policy makers, and has the prospect of generating further uncertainty and complexity in financial markets and for exchange rates.
Greater focus needs to be put on the way in which the inflation threat is being dealt with in some emerging market countries:
• in a number of those countries, problematic suggestions have been put forward to deal with the inflationary threat through subsidies; in others, talk has turned to the need for price controls and, in some countries, talk has turned to action and the prices of a large number of food items have been frozen by decree;
• in too many countries – especially the emerging economies –, the response to date has been such that real interest rates have been permitted to go negative, leading markets to question the seriousness with which policy makers are taking the inflationary threat;
• there remains important questions about the tradeoffs policy-makers in emerging economies are willing to make between growth and inflation. In many cases, the choices being made in those countries suggest a higher tolerance for inflation and a higher priority for growth. This, too, creates further uncertainties for global inflation and, especially, for exchange rates.
The degree of concern expressed on these issues has varied, and the policy response is made even more difficult by the recent downturn in commodity and food prices. Some observers are of the view that commodity prices have peaked – at least for the near term – reducing some of the pressure now aggravating both actual inflation and inflationary expectations. Others, echoing the debates that took place during the Asian crisis a decade ago, question the role that can be played by official interest rate policy, especially in the context of an inflation threat that stems largely from developments outside some of the countries facing that threat.
In sum, until the past few months, emerging market economies were seen to have escaped the worst of the direct effects of the financial crisis that has wracked the industrial world. But the ongoing worsening of the crisis and its impact on confidence across the world, its increasing impact on the availability of credit across financial markets, and the continued softening of activity in the industrial countries are having an increasingly significant impact on the emerging economies. Designing appropriate policies to deal with that impact is made particularly difficult by the uncertainties regarding the extent of the inflationary threat coming from volatile commodity and food prices. It is further complicated by the increasing interlinkages between the industrial and emerging worlds and the mutual dependence that seems to be growing between the economies of those two worlds.