Morgan Stanley economist Stephen Jen thinks the dollar could gain against emerging-market currencies as the global economy enters a period of stagflation.
Emerging market central banks, says Jen, will be less inclined to tighten than their American and Western counterparts due to political pressure and the fact that prices in these countries will be less responsive to monetary policy:
We are of the view that inflationary conditions will likely be negative for the currencies of many EM economies that are experiencing a negative terms-of-trade (ToT) shock. Stagflation would be even worse for these currencies. In contrast to developed markets, whose central banks could stay ahead of the inflation curve, we believe that developing market central banks will likely struggle to stay ahead of both the inflation and growth curves. The macroeconomic challenges to be faced by EM economies will be quite acute, and many EM currencies are likely to be penalised against the dollar.
Jen thinks that inflation in emerging markets is distinct because it is the result of multiple supply shocks, and because it is imported. Because of these factors, insists Jen, inflation in emerging markets will be unresponsive to monetary policy, and central bankers in these countries will therefore be reluctant to tighten policy. Also, in emerging markets, the average consumer devotes a much larger chunk of their disposable income to food and energy relative to consumers in developed economies. This makes action from central banks even more tricky:
EM economies’ CPI baskets contain much higher weights for food and energy products than developed economies’ CPI baskets. This is important, because to offset inflationary pressures in these products – which are increasingly determined by international forces – EM central banks will need to somehow generate enough deflationary forces elsewhere in the economy. In other words, for EM central banks to achieve their targets on inflation, in the presence of high internationally determined energy and food inflation, they would need to be willing to drive the domestic economies into deep recession – a proposition that we believe is unlikely to be politically acceptable.
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