Caught in a policy dilemma

Brazil cut interest rates unexpectedly on Wednesday even though inflation picked up in August. Speculation has swirled for the past week that China might ease lending conditions for some small- and medium-sized companies. Even a few of the industrialized nations, such as South Korea, face growing pressure to delay further interest rate rises as global growth prospects dim.

“Not everyone will be as trigger-happy as Brazil, but there is good reason to expect that central banks everywhere will become more accommodative,” said Frederic Neumann, co-head of Asian economics research at HSBC in Hong Kong.

Neumann said most emerging market central bankers were inclined to err on the side of promoting growth rather than fighting inflation, and those attitudes may become more entrenched as advanced economies stumble.

Central banks in South Korea, Japan, Indonesia, the Philippines and Australia all hold policy-setting meetings this week. Traders have bet on no interest rate changes from any of them, although futures markets priced in a roughly 25 percent chance of a small rate cut from the Reserve Bank of Australia as of Friday.

Borrowing costs are not exactly prohibitively expensive in most of Asia. Benchmark interest rates are either near or below the inflation rate in China, South Korea and India. Many Asian policymakers were slow to begin tightening when inflation first picked up in 2010, and the International Monetary Fund has prodded them to take even stronger action.

Compare that with Brazil, where the interest rate stood at a lofty 12 percent even after last week’s cut, nearly double China’s and more than three times as high as South Korea’s.

Now that global economic prospects have faded, central bankers are caught between high inflation that points to rate increases and weakening demand that argues for holding off.

Many economists had predicted price pressures would subside as the cost of oil and other commodities fell.

Crude oil prices are down more than 20 percent since an early May peak, yet inflation stands at a three-year high in both China and South Korea. In Brazil, the broadest inflation index rose in August for the first time in three months.

CALLING THE PEAK

Data due next Friday is expected to show China’s consumer price index eased a bit from July’s reading of 6.5 percent. Even if it slips to 6.2 percent on an annual basis, as predicted by economists in a Reuters poll, it would still be well above Beijing’s full-year target of 4.0 percent.

Worryingly, China’s consumer price index came in higher than economists had forecast in each of the past six months, suggesting inflation is stickier than many observers expect.

For Beijing, policy mistakes on either side carry political risks. Overplay the inflation threat and growth could slow, threatening jobs and leading to social unrest. But expensive food and housing are already sparking public ire.

Chinese Premier Wen Jiabao said last week that containing inflation remained the top policy priority.

The consensus view is that July was the high-water mark for China’s CPI, and other countries should soon see relief too.

“Inflation pressures are high, but peaking,” said Ju Wang, an economist with Barclays Capital in Singapore. “While we do not expect outright easing in any Asian country soon, we think policy tightening is close to the end.”

Not everyone is convinced.

Patrick Chovanec, a professor at China’s Tsinghua University, said China’s inflation problem is structural and won’t fade away just because oil or food prices ease.

“It’s not merely some price bumps along the way, it’s really the rapid expansion of China’s money supply,” he said in a Reuters Insider interview.

Growth may be slowing across the big emerging markets, but it is still strong. China’s economy grew 9.5 percent year-on-year in the second quarter. That means rising demand for goods and services will continue to underpin prices.

Tight labor markets can add to inflation pressures because workers demand higher wages to keep up with the rising cost of living. In Singapore, for example, the unemployment rate was just 2.1 percent in the second quarter, even though GDP fell sharply. Inflation accelerated in July.

The U.S. Federal Reserve’s pledge to hold interest rates near zero through mid-2013 provides a bit of cover for emerging market central banks that prefer to wait and see how dramatically the global economy slows.

The U.S. employment report for August showed no growth in jobs and the unemployment rate remained at 9.1 percent, deepening concerns that the world’s biggest economy may be tilting toward another recession.

President Barack Obama is expected to lay out a series of proposals aimed at speeding up hiring and job creation in an address to Congress on Thursday.

But if the U.S. economy worsens and the Fed decides to kick off a new round of bond purchases, emerging markets could get another dose of commodities-driven inflation pressure, much like they did earlier this year when the U.S. central bank’s $600 billion bond-buying program drove markets higher.

“For now, we expect Asian governments and central banks to take a precautionary economic policy stance, rather than acting aggressively to prepare for a double-dip recession in the West,” Standard Chartered economists wrote in a note to clients.