Catch 22 as Fed Exports Inflation

One of the consequences of ultra-loose monetary policy in the United States has been investors looking for yield in the emerging world.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

This policy has boosted inflationary pressures for food and fuel and has left many policy makers in emerging markets in a Catch 22 situation, according to HSBC.

“Inflation has reared its ugly head again and there’s a strong sense of déjà vu. Sharply higher food and fuel prices have been responsible for much of the initial shock and emerging markets are again the main focus of concern,” Philip Poole from HSBC Global Asset Management wrote in a research note.

“But this time around there is also a key difference: emerging market central banks are fighting the Federal Reserve,” Poole added.

With the fed funds interest rate close to zero, Poole believes the Fed is re-flating much of the emerging world.

“For emerging market central banks it’s 'Catch 22.' Tightening via rate increases runs the risk of sucking in more of the Fed’s liquidity,” he wrote.

This Catch 22 position has led in Poole’s view to some emerging markets failing to react strongly enough to second-round effects of increases in some prices, meaning inflationary risks are now to the upside.

Straight Back at You?

With inflationary pressures in the emerging world being driven by commodities, inflation is then feeding back into the developed world.

“Commodity price pressures generated in emerging markets are also feeding through to developed markets,” said Poole, who believes the impact is limited by the fact that fuel and food make up a far smaller percentage of people’s income than in poorer countries.

“For the most part, wages are not rising to compensate for this terms-of-trade shock which, as a result, is squeezing real incomes in the developed world,” he added.

“Stocks are in no sense a perfect inflation hedge but, subject to valuations, investors should seek out asset intensive exposure and exposure to cyclical sectors,” Poole said.

“The former should benefit from a valuation effect as a result of inflation and the latter from increased pricing power,” he added.