Interest Rates Tightening Bias to Spark Emerging Markets Forex Rally

By: Money_and_Markets

Jack Crooks writes: If you think the U.S. has inflation problems, get a load of this ...

Year-over-year consumer prices in Vietnam just surged by a whopping 26.8%. The month-over-month numbers jumped a cool 2.1% — or what the Federal Reserve would consider a comfortable pace for inflation in the U.S. over the course of an entire year.

The biggest problem facing the Vietnamese government in Hanoi is determining how to keep rising food and energy prices from derailing their roaring economy. And Vietnam isn't the only country choking on inflation.

In fact, according to my research, there are over 50 different countries around the world that are currently battling double-digit rates of inflation. Like Vietnam, most of these countries are emerging markets. And all of them are at risk of going from appealing growth story to economic disappointment at the merciless hand of inflation.

Today, I'll explain how, in sharp contrast to the Federal Reserve here in the U.S., central banks in key emerging markets around the world are proactively working to counter inflation. You may be surprised to learn how their currencies have responded.

But first, let's talk about the root cause of hyper-inflation. I'm a firm believer that to project the future with any degree of accuracy, you must first look to the past ...

Let History Be Your Guide

Investors watched stock indexes plunge this week as crude oil prices soared to new record highs. The Dow Jones Industrial Average has endured its worst June since 1930.

We can safely say that today's global inflation can be chocked up to the surging price of crude oil. And the rising price of food — thanks in part to rising crude oil — is also unleashing pain on consumers. These oil-led price shocks are nothing new. Indeed, they have become an awfully consistent precursor to recession — at least in the U.S.

Below is an excerpt taken from a report over at Morgan Stanley's Global Economic Forum:

"While much of the rise in oil and energy prices could be attributed to global demand for these products, from the perspectives of individual countries, oil and food price increases are supply shocks. Early work on the relationship on oil prices and developed market GDP suggests oil shocks were the dominant determinants of U.S. recessions.

For example, Professor James Hamilton (see Hamilton (1983) "Oil and the Macroeconomy since World War II", Journal of Political Economy , vol. 91, (April), pp. 228-48) claimed that, since 1973, every upward spike in real oil prices has been followed by a surge in the U.S. output gap. More specifically, Professor Hamilton demonstrated that an oil price shock had preceded (Granger-caused) all but one recession (in 1960) in the U.S. since WWII."

The U.S. economy, even with a fairly flexible and developed financial system, has had trouble with periods of sharply rising oil prices. Should we expect anything different from emerging economies whose capital markets aren't nearly as forgiving as those in the U.S.?

After all, it doesn't seem like crude prices want to loosen up their grip on the global economy.

This chart shows the $140 per barrel threshold being breached on two different occasions recently, but holding steady. Why is this important? Because yesterday that threshold collapsed; oil spiked to a new record high of nearly $143 per barrel. I'll leave forecasting oil to natural resource experts Sean and Larry, but suffice it to say crude prices still have quite a ways to climb.

The fact that a larger portion of consumers' expenditures in emerging economies goes toward food and energy makes this type of inflation the most dangerous. And tougher for officials to balance, I might add.

Which leads me to a key question on currency trader's minds today ...

How are Emerging Market Central Banks Attempting to Tackle Inflation?

After witnessing how the Federal Reserve has shredded the value of the U.S. dollar and slammed stocks by ignoring inflation, emerging market central banks are stepping up to the plate:

• We know that China is already making strides with its currency. Interest rate increases highlight their efforts.
• India's central bank raised its benchmark rate by 50 basis points, to 8.5 percent with immediate effect, its highest since March 2002 and the second increase this month. It also signaled that it would act again if needed.
• The State Bank of Vietnam sharply raised its benchmark interest rate to 12 percent from 8.75 percent, in an aggressive effort to curb surging inflation and tighten lending. Commercial banks are now allowed to offer depositors rates of up to 18 percent.

Will this bias toward tightening monetary policy spark a new emerging market Forex rally? Adjusting monetary policy to fight off inflation should normally be supportive of a currency. The logic here is that interest rates are going up and the investment appeal rises with it.

Mexico's peso strengthened to a five-year high after the central bank unexpectedly raised its benchmark interest rate a quarter percentage point to 7.75 percent. The same thing happened in Brazil. Bonds also rose as investors gained confidence that proactive monetary policy will manage to curb inflation, helping preserve the value of debt's fixed payments.

Bottom Line: Monetary policy has been too accommodative and must respond to the growing inflationary environment. The rising level of prices is going to require that most emerging market central banks take action. By working to strengthen the value of their currency they can hope to ease the strain of crude and food costs.

The line in the sand is quite fine. That's going to make it easy to scrutinize the efforts, or lack thereof, central banks take to counter inflation.

Best wishes,

Jack

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