Explaining the Pain

The new stagflation risk arises from the developing economies, which are making policy mistakes eerily reminiscent of those made by developed economies some 35 years ago.

First, there is a dangerous fixation on "core inflation." The idea here is that food and energy prices are exogenous (driven by external factors), and mean-reverting (tend to fall back to the long-term trend), and therefore of little consequence for monetary policy. The world's major central banks mistakenly targeted core inflation in the 1970s with disastrous results. And yet this blunder could be compounded in the current climate—because surging agricultural and energy prices are endogenous (driven by internal factors) to rapidly growing, commodity-and-food-intensive developing economies.

Second, policy interest rates in developing Asia—the world's most rapidly growing export sector—are currently being set at about one percentage point below the headline inflation rate. History tells us that such negative real, or inflation-adjusted, short-term interest rates only fuel an outbreak of inflation. The hope in developing nations is precisely what it was in the developed world in the 1970s—that mean reversion in food and energy will bring inflation back toward the "core" and take real short-term interest rates back into positive territory. Yet this is the sixth year in a row when food and energy prices have failed to revert to the mean.

Third, the developing world has a voracious appetite for hypergrowth as the principal means to alleviate poverty and raise per capita incomes. On one level, that bias is understandable: According to the World Bank, the number of poor people in Asia declined by more than 300 million over the 1990 to 2004 timeframe. Such impressive progress tempts policymakers to ignore the negative repercussions of hypergrowth—namely, inflation, pollution, environmental degradation, mounting income inequalities and periodic asset bubbles. Growth is viewed as the rising tide that obscures even the most jagged macro rocks.

All this tempers any enthusiasm for the adoption of anti-inflation policies by major developing economies. And yet, of course, in the end, inflation is the cruelest tax of all—especially for those at the lower end of the income distribution. This is a growing risk in the developing world and an increasingly tough problem for import-dependent economies in the developed world.
—Roachis chairman of Morgan Stanley Asia.

Keep Your Seatbelt Fastened
Mohamed El-Erian offers advice on how the world's economic leaders should navigate an especially challenging policy environment.