Morgan Stanley: Beware of Inflation in Emerging Markets

In Morgan Stanley's Global Economic Forum Manoj Padhan warns investors in emerging markets to be careful as inflation works it's way through these countries.  He says that each country needs to be evaluated as to how it's central bank is handling inflationary pressures:

Thus, it’s critical for investors now to discriminate among emerging market economies by assessing the extent of their inflation problem and the resolve of central banks in emerging markets to tackle it.  Our global emerging markets team points out that there is significant variation on both counts, but also that there are important common themes:

•           First, our teams generally expect inflation to ease towards the end of the year, but only slowly.  This is partly because rising headline inflation has already boosted inflation expectations and thus has spilled over into wages and other prices, making an orderly transition to a stable, lower level of inflation more difficult.

•           Second, the commitment of central banks to fight inflation seems to vary according to the growth outlook – the weaker the outlook, the weaker the commitment – and whether the central bank has explicitly embraced an inflation target.

Thus, with the exception of China and Korea, our emerging markets team expects every single central bank under its coverage to raise rates by the end of the year.

But will this restraint tame inflation?  Our metrics provide some grounds for scepticism. Global policy rates are negative, with the nominal global policy rate currently at 4.4% and global inflation in May around 5%. In emerging markets, Latin America is the notable exception, with a real policy rate of 3.6%. Asia (ex-Japan) as well as the Emerging Europe, Middle East and North Africa region have negative real interest rates; this suggests to us that policy isn’t restrictive and any decline in inflation will need either stronger policy action or a helping hand from commodity markets and global growth, or both.

As important as it is to understand these common themes, they obscure the diversity of the inflation story in individual regions and markets.  In what follows, therefore, we turn to our emerging market teams to paint a more detailed picture of the inflation backdrop and the associated policy challenges.