Investment bank Merrill Lynch has forecast that the Gulf countries – faced with inflationary pressures too high to tolerate – will choose “the lesser evil of currency appreciation” and de-peg their currencies from the United States dollar this year.
Merrill sees the currencies of China, Russia and the Middle East appreciating substantially against the US dollar in 2008 as a reaction against galloping inflation in these regions. As emerging market central banks decide to deal with the threat more aggressively, the current global economic expansion will come to an end.
“From an international balance of payments perspective, inflation is the natural end game to the build-up in global imbalances that we have witnessed over the past decade or so… Watch out for aggressive policy tightening… or capacity constraints,” Merrill said in a global economic report titled “Inflation”.
“The global economy has witnessed two pulls: excess consumption in the United States, leading to strong import growth and a large current account deficit; and a global savings glut in Asia and other regions, leading to strong export growth and large current account surpluses. This international financial system – dubbed by some Bretton Woods II because of its superficial resemblance to Bretton Woods, the system of fixed exchange rates that prevailed following the Second World War – has long ceased to be a market equilibrium.
On our calculations, nearly two-thirds of the US current account deficit is currently financed by central bank intervention supporting the US dollar,” Merrill’s researchers led by economist Alex Patelis said in the report.
By intervening to support the US dollar, emerging market central banks automatically offer their own currencies in return, effectively “printing” money and expanding domestic money supply. There is an effort to “partly sterilise” this expansion by issuing bills aimed at withdrawing part of this excess liquidity.
But as the amount of outstanding bills has soared, domestic interest rates have risen, and US interest rates have fallen, sterilisation efforts have increasingly become more difficult and costly, Merrill said.
“Against this background, it is easy to see why money supply growth has surged in Russia, China and Saudi Arabia, the three major financiers of the US current account deficit. The international linkage to domestic inflationary pressures becomes clearer. Until central banks acquiesce to currency appreciation pressures, upward pressures on domestic liquidity are maintained, and inflationary pressures just intensify. Anti-inflation policy measures that fail to address the currency link inevitably fail in the medium run,” the report said.
“Eventually, the system reaches its natural end point. Inflationary pressures become too high to tolerate, and the central bank chooses the lesser evil of currency appreciation.” Merrill Lynch expects this to take place in 2008, with the Gulf de-pegging its currencies from the dollar, and the currencies of China, Russia and the Middle East appreciating substantially against the US dollar.
Such appreciation would reverse global imbalances. It would also, however, effectively “export” such inflationary pressures back to the United States. An appreciating yuan, for instance, means more expensive imports into the US. This is a process that has already begun but is likely to intensify in the quarters and years ahead, Merrill’s economists believe.
The report posits that the surge in inflation has been the macro-economic “surprise” of 2008 so far, not the downside cut in growth rates. “Since we launched our forecasts four months ago, Merrill Lynch economists have ratcheted up 2008 global inflation
expectations by a full 0.8 percentage points, from 3.4 per cent to 4.2 per cent, while shaving growth just by 0.2 percentage point.”
Part of the pressure on emerging market currencies to revalue has come from the ongoing credit crunch, which has resulted in much looser global monetary policy, as central banks have tried to grapple with liquidity problems and the plunging US dollar.
“At the moment, real interest rates around the world are getting pretty close to zero. Looser monetary policy will certainly not help bring commodity prices down, particularly if the supply side remains constrained, as is the case in this sector. Thus, oil and other commodity prices could rise further in the coming months, particularly if output disruptions reappear across a number of sectors,” it said.
As many as seven of Merrill’s 10 indicators show “bubbling inflation”. Most worrying, it says, are tightness in food and energy markets, surging money supply growth, repressed inflation in emerging markets, the reaction function of central banks and the continued central bank financing of the US current account deficit.
“Deflationists can point to still no evidence of accelerating unit labour cost growth and to a cyclical growth downturn emanating from the United States.
“In nearly all our measures of inflation, the threat in emerging markets is greater than in the United States, where rising inflation is less likely against a weakening labour market and deflating home prices. The threat to US inflation would come primarily from emerging markets,” Merrill said.
Food and energy: Chicken and egg
When forecasting growth and inflation, most economists tend to think of commodity prices as exogenously determined. Viewed through this mirror, higher commodity prices undoubtedly lower growth and increase inflation, Merrill said.
“Many central banks also focus on core, not headline, inflation, assuming commodity prices are either mean-reverting or cannot be consistently influenced by monetary policy. Yet both views are obviously incorrect at a global [general equilibrium] level, where commodity prices, inflation and growth have to be jointly determined.”
Stronger demand growth should be correlated with higher, not lower, commodity prices, Merrill believes.
“Indeed, this has been the case during the past decade. Thus, any forecast of global inflation needs to include a forecast of commodity prices. Are we getting close to the end of the commodity price rally? What would bring about a substantial correction lower? We find that commodity prices have been driven higher by emerging market demand growth, and a substantial tightening in policy conditions in those countries is a pre-requisite for any downward correction.
“The longer-term outlook for food and energy prices remains favourable as emerging market demand has a long way to go and supply is constrained.
“Over the near term, we are worried about further commodity price ‘super-spikes’. Thus, central banks and markets that focus on core rather than headline inflation do so at their own risk, in our view.
“The existing cocktail of emerging market price subsidies and OECD consumer taxes has made demand for oil and other commodities very hard to rotate via moderate increases in global wholesale prices, reducing the price elasticity of oil demand.”
Merrill says inflation will force Gulf to de-peg currencies