Let’s explore an interesting development: the different inflation experiences of emerging countries and developed countries. In case you haven’t noticed, inflation in emerging countries is higher, demand-pull in nature, and advanced to the stage of a wage-price spiral; in developed countries, it is lower, cost-push in nature, and not advanced to a wage-price spiral.

Does this have any significance? One ramification could possibly be the unwinding of the secular growth stories of the emerging countries and a return to economic supremacy of the developed countries. It could also mean the stock markets of the developed countries will be more rewarding places over the next decade or so compared to the stock markets of emerging countries.

The cost-push inflation of developed countries is easier to resolve, I believe. It should ebb as long as central bankers refrain from overly stimulative monetary policy -- thereby letting the deflationary forces of the stagflation slow the economy to a non-inflationary path. And this is the course of action that the central banks appear to be following (e.g. a rate hike by the European Central Bank, little increase in the narrowly defined U.S. money supply in 2008, etc).

Demand-pull inflation and wage-price spirals tend to be more stubborn. Taming them usually requires a substantial tightening of monetary policy.  A greater setback in growth could be the consequence for emerging economies.

But the required policy restriction will also likely require emerging countries to give up on pegging their exchange rates to the U.S. dollar. That’s because higher interest rates attract capital inflows and generate upward pressures on the currency -- so if policymakers wish to fight a growing inflation problem, they can’t keep their fixed currencies.

A catalyst could come if and when U.S. inflation recedes and the Fed begins easing monetary policy. Emerging countries may not want to follow U.S. interest rates down (as required to maintain their currency pegs) because it pours more fuel on their overheated economies.

All of which begs a few questions. Could emerging countries now be mismanaging their economies to the extent they kill off their vaunted secular growth stories? They wouldn’t be the first to botch things: in the 1980s, Japan was said to be on a path to overtake the U.S. but then it fell into a two-decade deflationary period.

Like Japan in its heyday, China and India have been enhancing export competitiveness by maintaining artificially low currency rates. Could their well-publicized growth trajectories similarly prove to be chimeras? And could the U.S. and other developed countries once again emerge on top while providing the better stock markets in which to invest over the next decade or so?

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Larry MacDonald

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