Inflation in emerging economies: An old enemy rears its head

Emerging economies risk repeating the same mistakes the developed world made in the inflationary 1970s

There are an alarming number of similarities between developing economies today and developed economies in the early 1970s.

Inflation in developing countries are in deed more serious, as official figures often understate their inflationary pressure. Widespread government subsidies and price controls are one reason, and price indices are often skewed by a lack of data or government cheating.

The recent jump has been caused mainly by surging oil and food prices and speculation.

Governments have responded with more price controls and export bans. In the short run such measures may help to cap inflation and avoid social unrest, but in the long run they do more harm than good.

Some central banks have nudged up interest rates this year, but they have not kept pace with inflation, so real rates have fallen and are now negative in most countries. Many policymakers in emerging economies argue that serious monetary tightening is not warranted: higher inflation is due solely to spikes in food and energy prices, caused by temporary supply shocks and speculation.

The synchronised jump in global food prices suggests there is more to the story than disruptions to supply. Prices are also rising partly because loose monetary conditions in emerging economies have boosted domestic demand.

Another reason why central banks cannot ignore agflation is that it can quickly spill over into other prices. Food accounts for 30-40% of the consumer-price index in most emerging economies, compared with only 15% in the G7 economies.

Philip Poole, also of HSBC, says that many emerging economies have run out of spare capacity because investment has not kept pace with economic growth. Hence firms are more likely to pass on cost increases.

In another echo, those central banks often face intense political pressure to hold rates low to boost growth and jobs. To many Western economists and policymakers the solution is simple: emerging economies should allow more flexibility in their exchange rates. This would permit them to raise interest rates, and a stronger currency would help to curb import prices. Another solution is to tighten fiscal policy to reduce excess demand.

China has helped to hold down inflation in developed economies because its goods are much cheaper, replacing more costly goods. Competition from China also forces local producers to cut their prices and it curbs wage demands in rich countries. As China moves up the value chain it will pull down the prices of a wider range of products. China will continue to help hold down global prices—although possibly by less than in the past.