One of the most important issues for economic policy makers the past few months has been the rapidly increasing rate of inflation experienced by most countries around the world. While the U.S. gets the most attention, the problem is actually more acute overseas, especially in the developing world. There are now 50 countries globally with inflation rates above 10%. The average rate of inflation in developing markets is 9.1% according to the International Monetary Fund. In the U.S. the figure is currently 4.1% and growing. Europe’s inflation level is a little lower.

Why are inflation rates so much higher in emerging economies? A look at some of the differences between the U.S. and developing economies can help to understand the current situation and to analyze likely outcomes.

Developing economies are experiencing inf lation similar to that experienced by the U.S. in the 1970’s. Food prices are up substantially: 22% in China in the past year, according to the Economist magazine. Food comprises 30-40% of the CPI in most developing economies vs. 15% in most mature ones. The increase in food prices has led to rapid wage increase in many cases, as policy makers have understood that food costs are a political as well as an economic issue. Many developing economies have currencies which are pegged to the dollar. During a period of dollar weakness this has resulted in interest rates being kept abnormally low. The result has been an overly lax monetary policy given the strength of these economies, which has led to “overheating.”

The situation in the U.S. has some common elements and some which are different. Clearly prices have been driven up by commodity prices including the costs of food and energy. But on a relative basis these factors have a lower impact than they do in developing countries. This hasn’t (at least so far) translated into increasing wages. The U.S. labor force is largely service sector focused now and much less unionized than during the inflation shock of the 1970’s. Also, the threat of outsourcing probably acts as a barrier to wage increases. The U.S. economy is also remarkably flexible with a work force which historically has been willing to relocate and chance careers. With the slowdown in the economy, the U.S. also doesn’t suffer from over-stimulation.

Unlike the situation in developing economies, there are also deflationary forces at work in the U.S. Most notably, the cost of residential housing has fallen dramatically in the past two years. Since it peaked in April of 2006, the Case-Schiller index has fallen 22 consecutive months by a total of 20%. This is by far the biggest drop on record, and is difficult to reconcile with an argument for accelerating inflation. Contrast this with the 1970’s, when home prices in the U.S. rose by an annualized rate of 11.1%, almost tripling during the decade. The current fall in home prices is not accounted for in CPI, which only includes rental rates. Rental rates have fallen much more slowly than home prices.

Our likely view is that the U.S. will not enter into an inflationary spiral as it did in the 1970’s. Emerging markets are more at risk than the US with respect to 1970’s style stagflation, but such a result is probably unlikely in emerging markets as declining global GDP rates will naturally lead to lower commodity prices—a trend we are already beginning to see.

Bill Andersen, CFA