Why monetary policies of developed and developing countries will clash in 2014

When it comes to prices, most of the global economy is headed in opposite directions.

While prices are tumbling across developed nations, several developing nations are grappling with stubbornly rising prices.

Here’s a chart from a recent IMF report titled “Global Prospects and Challenges,“prepared for the Group of 20’s meeting this weekend in Australia:

imfdeveloped

From the chart, it’s clear that the US and the eurozone are facing low inflation. Japan, of course, has been submerged in deflation for most of the past two decades.

Given that inflationary pressures are so low across advanced economies, the IMF believes that “monetary policy should continue supporting demand given the still-large output gaps and ongoing fiscal consolidation.”

The 18-country eurozone, in particular, has experienced rapidly declining inflation, which is now well below the European Central Bank’s medium-term target of up to 2%.

More alarmingly, inflation levels in the eurozone are now converging with Japan’s.

Not surprisingly, the IMF believes that “in the euro area, more monetary easing is needed to raise the prospects of achieving the ECB’s inflation objective, including by supporting demand, given the weak and fragile growth, large output gaps and very low inflation.”

The international institution thinks further actions could include longer-term LTROs (possibly targeted to SMEs), and further rate cuts, including mildly negative deposit rates.

“With prospects improving, it will be critical to avoid a premature withdrawal of monetary policy accommodation, including in the United States,” it emphasises in its report.

In the case of Japan, the IMF notes that the central bank has already done a  lot of work to defeat deflationary pressures. “Inflation and inflation expectations have picked up, and there does not appear to be a need for further easing at the moment,” the report says.

At the other end of the spectrum, developing nations are grappling with rising prices,  or inflation. In these countries, there is a need for further tightening monetary policy.

Take a look at the chart below:

imfdeveloping

China, Brazil, India and Indonesia — all major developing economies — are experiencing rising prices and have been adopting tighter monetary policies, which includes raising interest rates.

The IMF believes exchange rate adjustments (currency depreciation) could also be beneficial as part of the tightening process, especially since that would help improve the current account deficit prevalent in several countries.

Overall, falling prices in developed nations support easier monetary policies, while developing nations are feeling the pressure to implement tighter monetary policy (if they haven’t already done so).

How this divergence in monetary policies will affect the global economy — and growth — in 2014 will be interesting to watch.

The US Federal Reserve’s tapering programme has already started affecting emerging markets; the divergence in monetary policies could add another layer of problems for the weak recovery in global economic growth.

Also, expect more verbal (mostly angry or exasperated) exchanges between developed and developing countries over the “lack of co-ordination in global monetary policies”.

[Image Credit]

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