International inflation gap hits decades-long low

The gap between inflation rates in developed and emerging markets has fallen to its lowest level for at least 20 years, as rising inflation in richer countries has almost converged with falling rates in the developing world.

The trend may allow emerging markets badly needed room to manoeuvre as the US Federal Reserve tightens interest rates, a policy that has traditionally forced developing countries to raise rates themselves or see their currencies weaken.

Emerging market inflation stood at 2.58 per cent for the year to February, less than 0.5 per cent percentage points above industrialised countries’ rate of 2.14 per cent — the smallest gap since at least 1997, according to data from JPMorgan.

“The pressures on currencies for big devaluations or depreciation will not be as big as they have been in the past,” said Marios Maratheftis, chief economist at Standard Chartered. “High inflation differentials erode returns so this makes [emerging markets] much more appealing to investors than they have been in the past.”

Analysts attribute the narrowing of the gap to factors such as improving economic growth in richer countries, which has inched up inflation in the developed world, and the relatively strong recent performance of emerging market currencies, which has helped keep prices in such countries stable.

Mr Maratheftis said changes in emerging markets, such as more orthodox central bank policy, more flexible exchange rates and lower budget and current account deficits, had also helped bring inflation down.

Although JPMorgan expects both emerging market inflation and the gap with developed world inflation to rise modestly from February’s lows, it maintains that both measures are likely to remain well below historic norms for the foreseeable future.

Joseph Lupton, senior global economist at JPMorgan, noted that recent rises in the Brazilian real, Russian rouble and Indian rupee had choked off imported inflation.

Since July, inflation has fallen from 8.7 per cent to 4.8 per cent in Brazil; from 6.1 per cent to 3.7 per cent in India, and from 7.2 per cent to 4.6 per cent in Russia.

Chinese inflation has also fallen, but economists attribute much of the dip to an unexpected drop in food prices in February, which few expect to be repeated.

Mr Lupton cautioned that the inflationary convergence was partly due to emerging markets growth running below its long-term trend, even as growth accelerates in the the developed world.

But Luis Costa, emerging market currency and credit strategist at Citi, said lower inflation was “absolutely crucial” for emerging market investors, arguing that inflows of foreign funds into such economies were likely to hold up, despite the US’s tighter monetary policy.

“It makes the comeback of nasty inflation less likely and it makes me more positive about how sticky capital flows [into emerging markets] can be.”

Emerging market equities have outperformed developed world ones so far this year, while the JPMorgan EMBI Global Diversified index of emerging market bonds has returned 14 per cent over the past year, even as the return from developed bonds has been zero.