Central banks in EM lack fiscal in inflation battle

banks in emerging markets are getting precious little help in their campaign to contain the impact of rising food costs that are a major driver of inflation.

After all, higher interest rates cannot make crops grow faster.

Economists bemoan insufficient outlays to boost agricultural productivity; a sharp drop in investment since Asia\'s 1997/98 financial crisis, which has left the region with less spare capacity as output expands; and a reluctance by politicians to counter the threat of overheating by tightening fiscal policy.

The Reserve Bank of India is a good example of a central bank in a bind.

In raising interest rates by a quarter-point on Tuesday, the bank said monetary policy should not have to do all the heavy lifting needed to limit price pressures in an economy close to matching China\'s breakneck growth rates.

Repeating its stock warning, the bank said it might be even harder to manage inflation if there was any slippage in next month\'s budget. The government is targeting a consolidated deficit this year of 8.3% of gross domestic product.

\"The fact that there has been relatively little progress on fiscal consolidation in India has put a greater burden on the RBI to tighten policy,\" said Brian Jackson, a strategist with Royal Bank of Canada in Hong Kong.

\"That\'s just the way things are: you can\'t always get the fiscal policy that, as a central banker, you\'d want.\"

As a largely rural nation, with 60% of its workforce labouring in the fields, India also needs to tackle glaring inadequacies in agricultural infrastructure.

It was late rains in December that caused onion prices to double, which in turn helped propel food inflation through the roof.

But India\'s patchwork quilt of small land holdings and inadequate irrigation limit overall farm yields, while poor transport and a lack of cold storage prevent many perishables like vegetables from reaching market in time to be sold.

\"Unless meaningful output enhancing measures are taken, the risks of food inflation becoming entrenched loom large and threaten both the sustainability of the current growth momentum and the realisation of its benefits by a large number of households,\" RBI Governor Duvvuri Subbarao said.

With rising incomes enabling hundreds of millions of people in countries like India to afford diets richer in pricier protein, food inflation could be here to stay.

For now, though, the rise in food prices to a record high as measured by the Food and Agriculture Organisation is of a greater concern in emerging economies, where people spend more of their incomes on food than in more advanced countries.

European Central Bank Governing Council member Ewald Nowotny said on Tuesday that he agreed with fellow Council member Axel Weber that euro zone inflation, which hit 2.2% in December, should peak in March at around 2.4%.

One reason why rich-country policymakers are not pressing the panic button, but are rather relying on tougher rhetoric to anchor inflation expectations, is that the leap in food costs in recent months has been more modest than in 2007-2008.

Michael Vaknin and Constantin Burgi at Goldman Sachs estimate that higher food and energy costs will, at the peak, contribute around 190 basis points (bps) to headline consumer price inflation in Britain, 170 bps in the United States and 160 bps in the euro zone.

From early 2012, these contributions will likely fade considerably, unless commodity prices surpass our forecasts,\" they said in a note to clients.

By contrast, in 2007-early 2008, the corresponding contributions were 400 bps, 300 bps and 200 bps, respectively, Vaknin and Burgi said.

The importance of food as a driver of inflation in Asia is hard to overstate. JP Morgan calculates that 86% of the rise in inflation in China since 2002 originates from food.

That is not to say that monetary policy does not have a role to play in preventing \"non-core\" increases in food and fuel costs from being passed on to consumers, which could raise demands for higher wages and thus set off a vicious cycle of inflation.

\"You can\'t make onions grow quicker, but you can raise interest rates and that will have an impact on inflation expectations and liquidity conditions,\" said RBC\'s Jackson.

\"It doesn\'t get to every single price pressure point in an economy, but it covers a lot of them,\" he said.

Still, greater agricultural efficiency would give Asian central bankers more time to \"look through\" temporary farm-price spikes and focus on underlying core inflation conditions.

The reason why Asia, including rich nations Japan and South Korea, does not go all-out to raise agricultural productivity is the priority governments attach to preserving farm jobs.

Take China, where corn yields are only half of those in the United States but domestic prices are usually twice as high as the international market.

That is because the government sets minimum procurement prices to encourage farmers to plant and thus maintain close to national self-sufficiency in food, said Bradley Sidwell, head of food and agribusiness research and advisory for North East Asia at Rabobank in Hong Kong.

By not importing more, China protects the incomes of 40% of the labour force that works the land, an important political objective. But the cost is inefficient farming.

Beijing could also boost productivity by extending mechanisation or setting up a US style rural extension service to spread better practice in the use of land, water and seeds.

But again, China would need to create enough jobs for farmers who were no longer needed to till the land. The problem cuts to the heart of the imperative for social stability.

\"You can appreciate the currency, you can raise reserve requirements on banks, you can cap food prices, et cetera. But, really, the one way to release food inflation is to increase the supply side,\" Sidwell said


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