The drastic monetary and fiscal policy measures taken by central banks and finance ministers in response to the global financial crisis have in many quarters kindled fears of possible inflationary consequences. In the current issue of Global Investor, Credit Suisse analysts reach the conclusion that for most industrialized nations these types of risks remain moderate for now. In the emerging markets, on the other hand, the inflation risks are growing. Although the countries in question are on a considerably more robust growth footing, they eased their economic policy in unison with the countries worst affected by the crisis and are only gradually tightening again.
Inflationary pressures growing in the GCC
Over the last year, the GCC moved from having some of the highest inflation rates worldwide to undergoing a sharp fall in consumer prices. Similar to other emerging markets, inflation risks in the GCC are now rising again, according to Credit Suisse analysts.
Average inflation in the GCC is estimated at 2% YoY in 2009, after 11% YoY in 2008. While the trend has been similar, price movements have not been uniform in the GCC. The strongest change in inflation was observed in Qatar while inflation remained fairly low and steady in Bahrain.
In 2008, the surge in commodity prices was both a source of strength but also of increased vulnerability in the GCC economies. The rise in food prices put upward pressure on inflation - food & rent subcomponents represent around 50% of various CPI baskets. Higher energy prices lead to a windfall in oil revenues, supporting strong economic growth and liquidity. Considerable increases in liquidity boosted credit expansion and a spending boom, which lead to supply side bottlenecks, especially in real estate.
The fact that the local currencies are tied to the USD, with the exception of the Kuwaiti dinar which is pegged to a basket of currencies, was an additional reason for the swings in inflation. Prior to the financial crisis, the weakness of the USD generated additional inflation pressure via import prices. In contrast, the surge of the USD during the financial crisis deepened the decline in inflation. Finally, the sharp decline in housing prices in some parts also contributed to an easing of inflationary pressures.
While fiscal policies in 2009 remained expansionary to support growth in the region, the weakness of commodity prices, lower liquidity and tighter credit conditions had a greater impact.
Going forward, Credit Suisse analysts see inflationary pressures growing across the GCC. This is based on their assumption that commodities, both softs and energy, will continue to rise, and their forecast that the dollar will weaken. According to Credit Suisse analysts, should the dollar hold up, inflation risks will be lower. Moreover, while the economic outlook remains positive for the overall region, the gradual recovery will most likely limit domestically driven inflation pressures.
Source: IMF, Credit Suisse (2009 average inflation rate is an estimate)
Too-Easy Monetary Policy Heightens Inflation Risk in Emerging Markets
Most emerging markets significantly eased their monetary and fiscal policies in the wake of the financial crisis in a bid to stimulate domestic demand. Since then, China – and to a lesser extent some other Asian emerging markets – have linked their currency closely to the US dollar. They are consequently "importing" a monetary policy that is designed to support an economy that has been badly affected by the crisis rather than one with structural strength. Accordingly, there are increasing signs of economic overheating in various emerging markets and inflation is already picking up. The indications are particularly evident in the real estate sector. Countering this trend requires a tightening of monetary and exchange rate policy and a further switch away from exports in favor of domestic demand.
Possible Feedback Effects Due to Rising Commodity Prices
One of the side-effects of the strong growth in the emerging markets could be an even stronger rise in global commodity prices. This development would have an especially strong impact on some emerging markets themselves, as the importance of commodities to production and consumption is greater here than in the industrialized countries. However, they too would be affected – though to varying degrees. As in the period prior to the financial crisis, this would not necessarily fuel the inflation trend, but would amplify the degree of volatility and therefore uncertainty about price developments.
Inflation risk seen subdued in continental Europe, higher in UK
Automatically equating the sometimes massive expansion of central-bank balance sheets - as occurred in the United States in particular - with potential inflationary consequences is regarded as too simplistic by the Credit Suisse analysts. The severe wealth destruction, sharp deterioration on the US labor market, and weakness of the banking system point to a fairly slow recovery in private demand. With capacity utilization still at a low level too, the inflation risk therefore continues to appear limited. In continental Europe and Japan, the inflation risks are seen as being even more subdued, while in the UK as well as rapidly growing commodity-exporting countries such as Australia they are higher. In the latter case, however, a tightening of monetary policy has already begun and this is likely to curb inflation risk in the medium term. As for Switzerland, inflation risks appear low owing to structural factors. The Swiss National Bank's expected move away from its policy of combating the strong Swiss franc is also likely to limit the risk. Nevertheless, as a result of persistently low interest rates, there are incipient signs of overheating on the Swiss real estate market.
Countries Unlikely to Inflate Their Way Out of Debt
One of the consequences of the financial and economic crisis is a further exacerbation of the imbalances in the government budgets of many industrialized nations and a corresponding surge in government debt. The Credit Suisse analysts consider it unlikely that the central banks will come to the rescue by inflating away these government debts. The independence of the central banks as well as the almost inevitable counterreaction of financial markets to such a policy reduces this risk. Nevertheless, it should be noted that the massive rise in government debt will make it more difficult for the central banks to engineer an exit strategy from monetary ease. This could be reflected in heightened uncertainty about the direction of monetary policy and an attendant increase in volatility on the financial markets.
Review and Adjustment of Portfolio Structures for Investors
Global Investor presents an analysis of the sensitivity of various asset classes to inflation and growth risks, and deals with the implications of potential inflation risks for investors. It illustrates how investors can optimize the structure of their portfolios in the face of heightened uncertainty regarding inflation. An examination of portfolio structures and modest increase in investments in «real» assets such as commodities is advisable as far as most investors are concerned. However, excessive portfolio reallocations would mean ostensible protection from inflation at the cost of greater overall risks to the portfolio.
