Global Markets Weekly - 12th May 2008

• Inflation concerns persist, despite evidence of slowing global growth.
  The sharp US slowdown and declining leading indicators in most regions of the world point to a deceleration in global growth. So it seems puzzling that investors should be concerned about a resurgence of inflation.
• Inflation is hitting emerging market economies hardest...
  The main factor determining individuals’ experience of inflation over the past two years is whether they live in a developed or emerging market economy. Although inflation has picked up in almost all regions, developed country inflation has only returned to its 2005-06 level and more recently has shown clear signs of stabilising. Inflation in emerging market economies has increased much faster.
• …because of rising food and energy prices...
  The direct explanation for this increase in inflation – and the developed/emerging economy dichotomy – is the rise in food and energy prices and the higher proportion of consumer income spent on these necessities in lower-income countries. Yet that is only half the answer; changing patterns of demand determine relative prices but don’t set the overall level of prices. The price level in any economy is determined by monetary policy – higher prices can’t be maintained without an increase in the money supply.
• …but the root cause is loose monetary policy, the result of fixed currencies.
  The exchange rates of many emerging market economies are, to varying degrees, linked to the US dollar, whether through the fixed pegs of Hong Kong and the Middle East, the crawling appreciation of the Chinese renminbi or the less overtly managed regimes of many other Asian currencies. The arrangement initially seems to make economic sense: exports to the US are a critical source of demand for these countries, so exposing this demand to the vagaries of the foreign exchange market would be risky.
• Countries with fixed exchange rates are having to respond to US rate cuts...
  When the credit crunch hit the US in mid-2007, the Federal Reserve (Fed) responded to domestically tightened credit conditions by aggressively cutting interest rates. Emerging market economies, which had not suffered the same sub-prime shock, were forced to emulate the Fed’s easy money policy either by cutting rates or by intervening more heavily in currency markets and thus boosting domestic money supply.
• …even though they have been largely unaffected by the credit crunch..
  Emerging Asian and Middle Eastern countries had to adopt a monetary policy designed for an economy suffering the convulsions of a credit crunch – even though their own banking sectors were largely unaffected. It’s no coincidence that emerging market inflation and the price of their main consumer good (food) accelerated in the third quarter of 2007 and have continued to do so as US rates have been cut further. So the inflation problems of many of these countries are not a product of rising demand growth – indeed, leading indicators show signs of turning over. Rather, it is the semi-detached economic problem of following an inappropriately loose monetary policy.
• Slowing US consumption should help - but may not be in time to prevent a crisis.
  Whether the problem is resolved depends on how far slowing US consumption feeds through to emerging market economies. Paradoxically, the more successful activist US monetary and fiscal policy is at limiting the consumer downturn, the greater the pressure on emerging market currency pegs and floats. As we have seen in recent months, when market imbalances adjust, they often overshoot in the process. Although the domestic inflation of most Asian and Middle Eastern countries has probably not yet reached crisis point, food price inflation is as good a guide as any of the pressures building in the system.

Indices, Interest rates and Inflation

	Close 04-Apr-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,164	0.0	3.7	7.0	-3.7
FTSE 100	6,205	-0.2	3.7	7.3	-3.9
S&P 500	1,388	-1.8	2.5	4.3	-5.5
Nasdaq Composite	2,446	-1.3	5.3	6.1	-7.8
DJ Stoxx (Europe)	366	-1.5	2.0	4.0	-11.8
Nikkei 225	13,655	-2.8	4.1	4.9	-10.8
Hang Seng	25,063	-4.5	4.5	6.8	-9.9

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Jun-08 Forecast	Sep-08  Forecast	Current	Next Date
US (Fed Funds)	2.00	2.00	2.00	4.0	25-Jun
UK (Base rate)	5.00	5.00	4.75	2.5	05-Jun
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.6	05-Jun
Japan (Call rate)	0.50	0.50	0.50	1.2	19-May

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