Too Much Money: Inflation Goes Global

Inflation has sent food prices skyward, sparking riots and protests in developing countries worldwide. Will central banks respond in time?
Kashmiri government employees shout anti-government slogans under a stream of colored water from a water cannon during a second day of protest by Kashmiri government employees in Srinagar on June 10, 2008. TAUSEEF MUSTAFA/AFP/Getty Images

In Spain and France, tens of thousands of striking truckers are blocking highways and border crossings to protest high fuel prices. In Egypt, police have clashed with throngs of protestors who barricaded roads after a cut in flour subsidies. And in India, riot police have used water cannons to disperse thousands of striking government workers in Kashmir protesting energy costs. These are but a few of the stories now making headlines around the world as protests against rising food and fuel prices gather pace.

Even as the world struggles with the continuing fallout from the U.S. credit crunch, it's fast becoming clear a new menace is now threatening the global economy: Inflation, the long-dormant bugbear of the 1970s and 1980s, has suddenly returned with a vengeance. And while much of the attention paid so far to the problem has focused on rising prices in the U.S. and Europe, the worrisome truth is inflation is also taking off throughout emerging markets.

Chinese inflation was 7.7% in May—down from a record 8.5% in April, but up from just 3.2% in the first half of last year. Indian inflation has risen from below 4% last August to above 8% last month. Russia's inflation has nearly doubled, from 7.6% to 14.3% over the past year. The problem is even worse in many smaller emerging markets. Inflation now exceeds 30% in Ukraine and Venezuela, and 25% in Vietnam. Saudi Arabia's inflation of 10.5% is its highest in 27 years. "It's very serious indeed," says Anders Aslund, senior fellow at the Peterson Institute for International Economics in Washington. "The problem is common to everybody."

Investors Won't See It Coming

On the face of it, the latest inflationary spike is linked to skyrocketing prices for commodities, notably oil and grain, but also many other metals and foodstuffs such as dairy products. Explanations include market speculation, poor harvests, and the weak dollar. But is it mere coincidence that so many commodity prices are shooting up simultaneously?

Probably not. Increasingly, many economists are arguing that spiking commodity prices are just the outward signs of a much deeper, and even more worrying, global inflationary surge. "I see no evidence that this is temporary or transitory," argues Harvard economist Kenneth Rogoff, formerly chief economist of the International Monetary Fund. Just as with the great inflations of the past, he warns, the true culprit is not shortages of select commodities, but too much money all around. "It's a disaster," warns Rogoff. "Investors are entirely unaware of what is about to hit them."

With the global credit-tightening still biting hard, it may seem surprising to argue that there's too much easy money. But there's a straightforward explanation for the seeming paradox. Although the credit crunch has led to fears of a serious slowdown in the U.S. and other developed economies, global price trends are more and more driven by emerging markets, notably China and India. In these countries, the credit crunch has had little impact, and economies are still roaring on full power—fueled by a surge in money supply.

Part of a Larger Problem

Many emerging-market central bankers and economists aren't alarmed yet, arguing that rising prices are the result of global forces outside local control and will abate when commodity prices cool off. Sachin Shukla, an economist at Indian brokerage Enam Research, notes commodities such as grains, metals, and oil account for 80% of Indian price increments. "The key question is: Will our policymakers overreact?" he worries.

Nevertheless, recent rate cuts by the U.S. Federal Reserve have exacerbated global inflation problems. Many emerging-market currencies effectively shadow the dollar, capping local interest rates. And there's growing evidence that the rise in commodity prices is part of a more general problem.

Investment bank UBS (UBS) notes core inflation rates are rising across emerging markets, reaching 6.8% in Latin America, 4.1% in Asia, and 8.3% in Eastern Europe. (Twelve months earlier, the respective rates were 5.0%, 2.4%, and 5.4%). "The most worrying feature of the global inflation landscape is that core inflation pressure and wage inflation pressure are building, particularly in the developing economy bloc," says UBS economist Andrew Cates. "That's quite a pressing problem at a time when monetary policy and monetary conditions in developing economies are still quite loose."

Pointing a Finger at Lax Money

There's plenty of evidence that lax money is partly to blame. In many emerging markets, including China, India, and Russia, benchmark real interest rates are negative. For example, Chinese inflation, which clocked in at 7.7% last month, is above the central bank's main lending rate of 7.47%. Among the four "BRIC" economies, only Brazil, where real interest rates are at record highs, stands out for its tight monetary policy. Yet even there, concerns about inflation are mounting.

UBS notes that in Latin America, Asia, and Eastern Europe, interest rates have been consistently below nominal GDP growth for the past five years. That's in stark contrast to the situation during the 1990s, when interest rates typically equaled or exceeded nominal GDP growth.

True, benchmark interest rates may be a poor measure of monetary conditions in many emerging markets. But other indicators are hardly more reassuring. Over recent years, emerging markets including China, Russia, and the Persian Gulf states have run immense current-account surpluses, building up record foreign exchange reserves (already some $1.76 trillion in China and $540 billion in Russia). Many economists draw the obvious conclusion that these countries' exchange rates are undervalued. The resulting buildup of foreign exchange reserves has contributed to growth in money supply, which feeds inflation.

Slower Growth May Be Unavoidable

Central banks are now waking up to the growing inflation problem and many have recently started to take corrective measures. On June 7, the People's Bank of China raised the reserve requirement ratio for banks a full percentage point, to 17.5%, an unusually large increase. On June 10, the Russian Central Bank raised its refinancing rate—for the second time in a fortnight—by a quarter of a point, to 10.75%. The central banks' actions have gone some way toward addressing economists' concerns that inflation is now getting out of hand. But the inevitable monetary tightening also means slower economic growth in emerging markets is now inevitable—in itself bad news for the global economic outlook.

There may also be more fundamental reasons to be gloomy. The present wave of global inflation could indicate emerging markets' long boom has finally reached its limits. As emerging economies run up against growing capacity and resource constraints, a prolonged period of slower growth and higher inflation may now be unavoidable. "This is typical of what happens in a long business cycle," says Aslund. "This is the best business cycle that the emerging markets have ever seen." What happens then, he adds, is that policymakers can become complacent.

Indeed, one big risk is that central bankers in emerging countries—accustomed to year after year of phenomenal growth—will be reluctant to admit times have changed. "The problem here is that in trying to avoid a modest slowdown, central bankers are resisting raising interest rates," says Rogoff. "But it may become extremely painful to bring down inflation in the future. It took a decade in the '80s to do it. If the central banks wait too long, we're going to be back in the soup."

With reporting by Manjeet Kripalani, Chi-Chu Tschang, and Joshua Shneyer