Inflation: The Great New Divide

For most of the post-World War II era, the U.S. was the locomotive that pulled the global economy out of recessionary valleys. This time it has been emerging-market nations, mostly Brazil, China, and India, that have surged, carrying the U.S. along like a big, fat caboose. Exports accounted for a little more than half of the growth the U.S. economy managed to generate in late 2009 and early 2010, according to data compiled by the Commerce Dept. About 40 percent of U.S. exports went to emerging markets.

Now inflation in emerging markets—and near-deflation in developed economies—could slow the growth train. Rapid expansion is driving up inflation and generating asset-price bubbles in China, India, and other fast-rising economies. In a sign of how entangled the global economy is, capital from the developed bloc may also be stoking the inflationary fires in those and other countries. Chinese and Indian policymakers are trying to cool things by curbing government spending, raising interest rates, or both. If they accidentally crack down too much, they won't be able to play the role of locomotive. That would be a blow to a U.S. economy that is already threatened with a pause or, at the extreme, a double-dip recession. Also at risk are Japan and Western Europe, which, like the U.S., are wealthy but slow-growing and facing deflationary pressures.

Economist Edward Yardeni regards the divergence between the world's inflationary and near-deflationary zones as one of the key threats to the global expansion. "If the central banks in the [emerging-market countries] are forced to tighten their monetary policies to dampen inflation, their growth rates could be depressed," he wrote in his newsletter in mid-July. "The inflation problem is in exactly the countries you don't want an inflation problem," he adds in an interview with Bloomberg Businessweek. The challenge won't go away soon because emerging markets are likely to remain the world's growth engines for years to come. "The gap in growth rates is a long-term condition," wrote Stephen King, chief economist of HSBC (HBC) in London, in a July 26 e-mail.

The accompanying graphic tells the story of a divided world. On the right are large, light-colored bubbles representing India, China, Turkey, and Brazil. These are countries with relatively low incomes, rapid economic growth, high inflation rates, and increases in inflation over the past year. The other prominent cluster is the wealthy nations in North America and Western Europe, plus Japan and Australia. They have higher incomes, slower growth, lower inflation rates, and smaller increases in inflation. Japan (diamond-shaped) is the only country suffering outright deflation. Russia's big drop in inflation makes it an outlier, befitting its halfway position between the rich and poor nations.

Domestic factors such as constraints on manufacturing capacity and labor shortages are the biggest reason for emerging-market overheating. The Federal Reserve, by keeping U.S. interest rates ultra-low, may inadvertently be adding to the problem. The Fed could be feeding bubbles in emerging markets by inducing global investors to move money out of the U.S. and into countries that offer higher yields, says Jon Levy, an analyst for Eurasia Group, a think tank. Two-year government notes yield 12 percent in Brazil, vs. about 0.6 percent in the U.S. Says Levy: "The response to deflation pressures in the U.S. creates inflation pressures elsewhere."

The official inflation numbers can mask serious problems. Chinese consumer prices rose 2.9 percent over the past year. In Beijing, though, inflation-adjusted land prices have increased nearly 800 percent since the start of 2003, with half that increase in the past two years, according to research by Joseph Gyourko of the University of Pennsylvania's Wharton School and Jing Wu and Yongheng Deng of the National University of Singapore.

Sam Finkelstein, global head of macro strategies for Goldman Sachs Asset Management, says he's optimistic that officials of major emerging-market nations will avoid a serious slowdown. Americans had better hope so: The annualized U.S. growth rate of the Economic Cycle Research Institute's U.S. Weekly Leading Index fell in mid-July to its lowest point since early 2009. "It's never been here before without there being a recession," David Rosenberg, chief economist of Gluskin Sheff & Associates, a Toronto money management firm, wrote on July 26. Time for the emerging markets to come to the rescue.

The Bottom Line: The world economy is evolving into inflationary and near-deflationary zones. Emerging markets must slow down without crashing.

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