Bernanke's Emerging-Market Disciples May Need to Follow Volcker

By John Fraher and Shamim Adam


July 7 (Bloomberg) -- Policy makers in emerging economies from Russia to Vietnam may have to start acting less like Ben S. Bernanke and more like Paul Volcker if they want to bring inflation under control.

With currencies tied to the U.S. dollar, officials in many developing countries have had to keep their monetary policies linked to the Federal Reserve's. Now, after chairman Bernanke led the Fed's most aggressive easing in two decades, their central banks find themselves with interest rates too low for their economies and the worst bout of inflation in a generation.

``There's a lack of independent monetary policy; it's been inappropriately stimulative,'' says Nariman Behravesh, chief economist with Global Insight in Lexington, Massachusetts. The answer, he says, may be to ``tighten credit more aggressively,'' the way then-chairman Volcker did in the early 1980s.

Such a policy shift would mean pushing borrowing costs above the level of inflation and keeping them there even at the cost of a steep slowdown that might send commodity prices into a tailspin. Faced with inflation that approached 15 percent in 1980, Volcker pushed interest rates as high as 20 percent and drove the U.S. into its deepest recession since the 1930s.

Prices are now surging across the developing world. China's inflation rate stayed near a 12-year high of 8.7 percent in May; prices in Vietnam jumped 27 percent in June and Indian wholesale prices increased 11.6 percent last month, the fastest in 13 years. Inflation exceeds benchmark lending rates in China, Russia, India and at least a dozen other emerging economies.

Doing Something

``They can't sit on their hands any longer, and need to start reacting in order to be seen to be doing something,'' says Robert Prior-Wandesforde, an economist at HSBC Holdings Plc in Singapore. ``Interest rates do need to go a lot higher.''

Rate increases big enough to slow down some of the world's fastest-growing economies would help Bernanke, 54, and European Central Bank President Jean-Claude Trichet in their own inflation fights by cooling the commodity-price boom.

Trichet, 65, said in an interview last month that there's a risk of inflation ``exploding'' if central banks don't act decisively; the ECB last week raised its benchmark lending rate a quarter point to a seven-year high of 4.25 percent. The price of oil has almost doubled in the past year, touching a record $145.85 on July 3, and wheat and rice prices jumped more than 50 percent in the same period.

Food and Energy

The surge in commodity prices poses a particular problem in emerging economies because food and energy account for a bigger share of overall inflation than in the U.S. or Western Europe -- more than 40 percent in India, Thailand and Turkey, compared with about 25 percent in the U.S., Morgan Stanley says.

Volcker's track record is already being invoked by some officials in Asia. Singapore Finance Minister Tharman Shanmugaratnam on June 27 praised the former Fed chairman, now 80, for ``reversing the psychology of inflation'' and said Asian central bankers must realize they need to tighten credit before it's too late. Volcker wasn't available for comment.

While India, Taiwan, the Philippines, Chile, Mexico, Egypt, Brazil and Russia all raised interest rates last month, the danger is that they've already waited too long, and that measures strong enough to curb inflation now would risk sinking their economies.

`The Sheer Difficulty'

``The sheer difficulty of achieving stability on the growth and inflation fronts will be a shock for Asian assets, equities and currencies,'' says Stephen Jen, chief currency strategist at Morgan Stanley in London. ``It's almost impossible for them to get ahead of inflation.''

Jen says China needs to lift its real interest rate, currently near zero, by about 8 percentage points. JPMorgan Chase & Co. calculates that the average real rate across emerging nations stands at 2.3 percent, compared with 3.7 percent a year ago.

``They're hundreds of basis points away from a restrictive policy,'' says David Hensley, JPMorgan's director of global economic coordination in New York.

The monetary policies of emerging economies, devised in the aftermath of the Asian financial crisis a decade ago, now are part of the global inflation problem. By directly or indirectly tying their currencies to the dollar, many emerging economies suffer the imported inflation that normally accompanies a weakening exchange rate.

Dollar Link

The dollar link, though, also ties their policies to those of the Fed, which cut its key lending rate by 3.25 percentage points in eight months even as the inflation rate doubled.

China still limits trading in the yuan three years after dropping a peg to the dollar. Malaysia continues to ban offshore trading of the ringgit, and Vietnam controls its currency's trading band against the dollar.

Bank of England Governor Mervyn King said June 26 that Asia is contributing to global monetary policy that's ``a little lax.'' A day later, Fed Vice Chairman Donald Kohn urged ``actions to contain inflation'' in the world's fastest growing economies.

Some central banks are also constrained by political pressures that have made them too willing to accommodate growth, says Venkatraman Anantha-Nageswaran at Bank Julius Baer & Co.

Caving In

China's central bank, which is controlled by the government, has yet to make good on a pledge to raise rates this year. Indonesia's central bank last year caved in to pressure from Vice President Jusuf Kalla to cut rates. Inflation accelerated to a 21-month high of 11 percent, leading the bank to raise the benchmark rate last week for the third month in a row.

In Malaysia, Second Finance Minister Nor Mohamed Yakcop on June 24 said the central bank is ``not independent of the government'' and that inflation at a nine-year high doesn't pose a ``major challenge.''

``The prosperity story has been built so much on leverage and liquidity and they need growth to keep on rolling,'' says Anantha-Nageswaran, Julius Baer's Singapore-based head of research in Asia. ``They are so afraid that what they've built is not a house of bricks, but a house of cards. There is a lack of institutional maturity in Asia.''

Inflation-targeting systems have also had limited success. Turkey last month abandoned its price goal after missing it for two years; Russia is struggling to hit its own target while managing the ruble. Morgan Stanley says inflation exceeds targets in at least 19 emerging economies.

In the absence of effective strategies, a ``hard landing'' may be the only way to get inflation down, says Morgan Stanley's Jen.

``There does not seem to be another way out,'' Jen says. ``Until recently, the emerging markets were seen as a safe haven from the financial crisis. The tables have turned.''