Sunday, July 27, 2008

Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso

``Thinking is the hardest work there is, which is probably the reason why so few engage in it."-Henry Ford

Perhaps Stephen Jen of Morgan Stanley has read our arguments and has written an article providing an academic cover for our view. He says which I quote,

``whether inflation is positive or negative for long-term economic growth depends on whether money is a substitute (a store of value) or a complement (a medium of exchange) for physical capital.

``This theoretical debate can only be settled by statistics. Here are some key statistical facts about this relationship:

``-No clear systematic relationship between inflation and long-term growth. Unlike the Phillips Curve relationship, and contrary to popular presumption, the long-term statistical relationship between inflation and growth has been rather unstable and inconsistent, over the past decades, and across countries. There were episodes of high inflation and high growth, as well as high inflation and low growth.

``-High inflation (15-30%) was often accompanied by high economic growth. When inflation rates breach 40% or so, inflation is almost always bad for growth. However, inflation of around 15% has historically not been particularly problematic for economic growth. In the 1960s, Asia and Latin America experienced high growth-high inflation phases. Per capita income growth in these countries actually accelerated when inflation rose from single-digit to double-digit levels. Further, such a state had been sustained for a long time without major disruptions. Even now, China and India’s rapid economic growth rates are accompanied by rising and high inflation, with no apparent extreme tensions in the economies.

``-Inflation reduction has output costs. Stabilisation of hyper-inflation has had no major output losses. But reducing inflation from ‘high’ to ‘moderate’ has led to costly output losses. The experience of the US under Fed Chairman Volker – with the US economy going through a recession and a period of high unemployment to bring down inflation – is particularly representative of this process.

So in effect, the impact of inflation depends on the policies of balancing the economic growth aspects relative to the risks of inflation and can be assessed only from a micro angle or from a case to case basis and not from wholesale assumptions, see figure 4.

Figure 4: ADB Change in Inflation and Output growth (in basis point)

The ADB chart exhibits the trade-offs between more inflation and less output across the region’s economies. Each country has different impacts to the problem of inflation.

Mr. Jen concludes (highlight mine), ``The role of fiat money is key in determining whether this relationship is positive or negative. For some EM economies, this relationship could be positive, justifying central banks protecting growth and allowing inflation to rise. Investors should be aware of the risk of EM central banks having a moratorium on inflation-targeting.”

As we commented last week in Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation where popular inflation indicators seem to be on the mend as declining food and oil prices across the board signifies a decline in global economic growth than from government policies, the recent substantial broad based food and energy declines abroad confirm these trends as recently posted Why Food Inflation Will Ease Over The Interim (in pictures).

Moreover, market signals combined with political pressures have been putting the lid on these pressures too. We are seeing more and more efforts from the private sector in response to market signals to increase supply as the “Adopt a Farmer” by some business and socio civic groups.

Figure 5 ADB: Updated Food and Energy Weightings in CPI basket

Remember principally it is rising food prices creating the inflation hysteria, see figure 5. The pain comes from food (46.6% of CPI) and not much from fuel (2.4%). This explains why car sales remain firm despite the rising cost of fuel contrary to popular wisdom as projected by media.

The Bangko Sentral ng Pilipinas (BSP) also holds sway on the direction of the Peso and financial markets. If the BSP manages to increase rates enough to close the real rates gap, then it is likely that the currency yield arbitrage, aside from reducing imported inflationary pressures are likely to attract foreign investors back to the market.

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