US inflation to pose risk to emerging markets

At the virtual Jackson Hole meeting held recently, FED Chairman Jerome Powell managed to convey a likely shift in the policy of quantitative easing without unleashing a taper tantrum as previously happened in 2013.

The CPI in July has jumped 5.4% YoY to mark the biggest increase in 13 years. Meanwhile, the PPI in August accelerated 8.3% YoY, the biggest year-on-year advance since November 2010, after surging 7.8% in July. The rise in PPI suggests that high inflation is likely to persist for a while as the unrelenting COVID-19 pandemic continues to pressure supply chains.

At the virtual Jackson Hole meeting held recently, FED Chairman Jerome Powell managed to convey a likely shift in the policy of quantitative easing (asset purchases) without unleashing a taper tantrum as previously happened in 2013. Dr. Ira Kalish, Chief global economist, Deloitte Touche Tohmatsu Limited, said that is a significant accomplishment. Recall that, in 2013, then Fed Chair Ben Bernanke announced that the Fed would soon ease, or taper, the pace of asset purchases that the Fed had initiated during the financial crisis of 2008-09. The decision made sense, but it caught investors off guard. The resulting sharp rise in bond yields came to be known as the taper tantrum. At that time, investors feared that, without the support of the Fed through asset purchases, the market for Treasury bonds would collapse. Fortunately, investor fears turned out to be wrong. The market ultimately recovered nicely, but not before there was much damage, especially to emerging markets. They experienced substantial capital flight as investors poured money into higher-yield US Treasuries.

FED Chairman’s speech was met with a collective yawn. Bond yields actually fell in response to his remarks. Evidently investors have learned a thing or two from the experience of 2013. Moreover, Powell has done an excellent job of communicating his intentions and helping investors to set realistic expectations, said Dr. Ira Kalish.

In fact, there are those that worry about what might happen next. One person who has expressed concern is Gita Gopinath, Chief Economist of the International Monetary Fund. She said that emerging markets are facing much harder headwinds. They are getting hit in many different ways, which is why they just cannot afford a situation where you have some sort of a tantrum of financial markets originating from the major central banks. “The economic consequences of the pandemic have been especially harsh for low- and middle-income countries. Not only have they seen damage to economic growth, they have also experienced significant inflation, compelling many emerging market central banks to raise interest rates to fight inflation, stabilize currencies, and avoid capital flight. Thus, a taper tantrum would make a bad situation even worse”, Ms. Gita Gopinath stressed.

Ms. Gopinath said that a lot of the problems we’re facing, even with regard to inflation and supply bottlenecks, have to do with the fact that we have the pandemic raging in different parts of the world. She added that, if higher inflation persists, that can feed into inflation expectations and then have a self-fulfilling feature to it.

Ms. Gopinath concluded, “We are concerned about a scenario where you would have inflation come up much higher than expected, and that would require a much quicker normalization of monetary policy in the US.” In other words, she worries that Powell’s relatively benign expectations of US inflation could turn out to be wrong, thereby leading the Fed to tighten faster than currently expected. In such a scenario, bond yields might jump precipitously.

Meanwhile, the Governor of Russia’s central bank, Elvira Nabiullina, echoed Gopinath’s sentiment, warning that the global economy could face a repeat of the 2008 crisis if the Federal Reserve is compelled to significantly tighten monetary policy. She said that the sharp rise in public and private sector debt during the pandemic creates greater risk and sets the stage for financial disruption.

Specifically, she said that, under a negative scenario, “risk premiums will increase significantly, the most indebted countries will struggle to service their debt, and a significant financial crisis will begin in the global economy in the first quarter of 2023—one comparable to the 2008-2009 crisis, with a long period of uncertainty and a protracted recovery.” Russia’s central bank, like those of several other major emerging markets, has already significantly increased its benchmark interest rate to quell inflation, avert capital outflows, and stabilize the currency.