On Wednesday, the CPI number for October in the U.S. will be released. Investors will surely watch this number closely. Growth rates of PPI and import price have all increased in October compared to September. CPI is expected to stay at current 1.1 percent, which is well below the level that the Fed feels appropriate.
Inflation is a much more immediate threat for emerging markets. As I suggested in previous articles, inflation in emerging markets (especially China) will dampen the rally of risky asset prices. The sharp market corrections in the past few days suggested that the rising inflation in the developing world and the implication on monetary policies in those economies began to be factored in the asset prices. Investors right now believe that central bankers in emerging markets (particularly China) will have to raise interest rates again, before the end of year. Some are even speculating two rate raises from the PBOC before 2011.
Now, when we are guessing what are on these decision-makers’ minds, it does not hurt to look at the same history that these decision-makers are studying. In China, the bust of Japan’s asset bubble in 1989-1990 and the following “lost decade” is probably the most mentioned case in the public debates. Chart 1 presents the inflation rates, Nikkei 225 index, and the policy rate decisions that the MOF/BOJ took between 1989 and 1991. The MOF/BOJ began to raise interest rates from 2.5% to 3.25% in May 1989 when the inflation rate was at 2.4% in April (up from 1.1% in March 1989, maybe due to the one-off national consumption tax effective on April 1, 1989). Seven months later, the Nikkei 225 rose by about 15% from March to its peak in December. During the same period, the MOF/BOJ took an aggressive position to combat the inflation. It stopped raising rates after August 1990 at 6%, more than double the rate in early 1989. At the time, the Nikkei 225 index had dropped by nearly one third from its all time peak in December 1989. Japan’s inflation continued to rise over the following months. The peak of Japan's inflation rate was at 4.2% in November 1990, three months after the MOF/BOJ got its top. And the price of the hawkish monetary policy is the “lost decade”.
Chart 1. Japan Inflation, Interest Rate, and Stock Market (1989-1991)
click to enlarge
The next most important lesson for policy makers is their own history. Chart 2 shows China’s inflation rate, the PBOC’s reaction, and Shanghai stock market changes between 2006 and 2009. China’s inflation began to rise in spring 2006. The pace was gradual at first and the PBOC reacted with increasing rates slightly. In 2007, the inflation problem started to go beyond control, from 2.2% in January 2007 to near 7% in November and December. The PBOC raised rates six times in 2007 from 5.58% to 6.57% (Since the PBOC has much greater control over bank rates than its counterparts in the western economies, I use the financial institution 6m base lending rate as the proxy for the official interest rate here). From January 2007 to October 2007, the Shanghai composite index increased by more than 100% in ten months. Although each time the PBOC only took a small step, there were other additional administrative measures that were implemented to control the credit growth. Then in the last two months in 2007, the Shanghai stock price index dropped by more than 10% from its peak near 6000 to 5200 level. It continued to fall till the end of 2008 (two-thirds had lost then). But the inflation rate did not reach the peak at 8.5% until April 2008.
Chart 2. China Inflation, Interest Rate, and Stock Market (2006-2008)
Chart 3 shows the familiar history of the inflation in the US, the Fed’s monetary policy, and the S&P 500 between 2004 and 2008. The inflation was near 4% when the Fed raised interest rates to 5.25% in July 2006. Then it seemed that the Fed’s policy was effective. Inflation was down while the S&P 500 was up in the next 12 months. Then, inflation was back and the bubble began to burst almost at the same time.
Chart 3. The US Inflation, Interest Rate, and Stock Market (2004-2008)
What are the conclusions that policy makers are likely to draw here? Let’s consider that policy makers need to keep a balance between controlling inflation and maintaining economic growth (measured by stock market performance here). First, it is well known that using interest rates to rein in inflation is difficult, even more so for big, export-led economies. If central bankers are too aggressive, the economic growth will suffer (Japan and China) and may never come back (Japan). And the longer term result is that policy makers will have to spend or print more money down the road: Japan’s accumulating public debts in the “lost decade” and China’s dramatically credit growth &”4-trillion-yuan stimulus” in 2009 (which led to the inflation problem today). Another lesson is that it takes a lot of time and several aggressive rate raises to burst an asset bubble. Since the tightening monetary policy was implemented, Japan, China, and the US took seven months, nine months, and a few years to reach the peaks of the bubbles respectively.
The least worst path of course is to gradually shrink the bubble and stabilize the inflation at the same time. I am not sure if anyone can really pull it off. But policy makers are certainly going to try. Right now, we are still at the early stage of another period of the tightening monetary policy in emerging economies due to the QE2. If policy makers have learned their lessons, we can expect that 1) there will be fewer and smaller interest rate raises down the road; 2) more administrative measures will be used (subsidies and loan quotes); 3) more capital control and other price control measures (regulatory risks); 4) persistent inflation problem in the emerging economies; and 5) frequent back and forth policy measures to maintain the market confidence. Demand for commodities will be reduced, but policy makers will try to set a floor for asset markets to limit the downside risks (stocks and properties). More policy measures will be announced to boost domestic consumption and service industries (except for housing markets).
Disclosure: No position