Market Economics | Interest Rate Strategy - BNP PARIBAS ...

US monetary conditions, because the USD is the
global reserve currency, also affect countries which
peg or dirty float against the USD. Many of these
have output gaps and inflation dynamics that are
hugely different from those in the US. Importing
super-soft US monetary policy is bound to lead to
them having an inflation and asset-price risk. It
appears to us that very few of these countries have
excessively tight monetary policy, which is the usual
excuse for their intervening to hold currencies down
or using ‘macro-prudential’ policies (aka capital
controls) to achieve the same ends. In fact, most of
them have monetary policies that are too soft. We
would argue that this is their choice and that inflation
is a very likely result. They will see their exchange
rates appreciate in real terms against the USD
through excess inflation. Our preference would have
been for nominal exchange rate appreciation, which
would contain inflation, not aggravate it.
Overall then, monetary conditions look too soft for a
world where inflation is developing some hotpots and
where capacity is used up. Asia is most vulnerable,
Latam a bit less so.
Expectations
Economic theory puts a big weight on inflationary
expectations in the story of how inflation is
propagated. Unfortunately, these are difficult to
model and predict and they may shift in a discrete
way. The process by which inflation expectations are
formed is probably one where they depend upon:
• What people experience;
• What central banks do; and
• What central banks say.
This determining relationship may not be stable. For
example, in the UK, people have been experiencing
significantly above-target inflation for a long time.
The longer this continues, the greater the weight is
likely to be on what they experience and the less the
weight will be on what the Bank of England says.
Therefore it may have to raise rates to keep inflation
in check. We do have measures of inflation
expectations for various countries, but for our
purposes here we would like a consistent measure.
The Ifo institute provides a measure of inflation
expectations, with Charts 9 to 14 (attached)
summarising the picture. What we find is that, after
the financial crisis, inflation expectations plunged.
There was a clear danger everywhere of this
undermining activity and leading us into deflation, at
least in some of the most important economies.
Aggressive monetary policy counteracted this and
inflation expectations rose sharply in late 2009-early
2010. These overshot – reaching levels similar to
Chart 8: Latam and Asia Ex-Japan FMCI
Source: BNP Paribas
those at the peak of the cycle in 2007 – and have
since come back, especially in North America and
Western Europe.
The current picture is:
• Inflation expectations in North America are very
low, and declining, though not as low as in late
2008/early 2009 when deflation was being
expected. There is no threat to inflation from
inflation expectations in N America.
• Inflation expectations in Western Europe have
come back from their peak, which was the
highest in two decades. We should not
concentrate on the fall since then as it was
probably an exaggeration. The level of inflation
expectations compared with the average since
EMU began in 1999 is moderate to strong.
Clearly, as the ECB has shown in its recent
press conference, they want watching.
• Inflation expectations in the CEE countries are
worryingly high and on a sharp upward trajectory.
CIS expectations are also high.
• Asian inflation expectations have not come off
their peak very much. They are high, though not
as high as in the early-2008 food price scare
episode. Nonetheless, with monetary conditions
slack, inflation expectations in Asia look
uncomfortable and deserve very close
monitoring, especially as food price surges look
to have an important impact in the inflation story.
• Latam inflation expectations are high, even
though they are lower than the peaks at the end
of the last cycle and the 2010 ‘QE will cause
inflation’ scare.
Central banks are talking about achieving price
stability, but decisive action is not being taken (e.g.
Paul Mortimer-Lee 20 January 2011
Market Mover
7
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