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by Richard Barley, WSJ

While the U.S. Federal Reserve frets about deflation, in some parts of the world inflation may now be the bigger danger.

Although the IMF expects headline inflation in emerging markets to fall to 5% in 2011 from around 5.75% now, pressures are building in some developing countries. India’s inflation rate hit double digits earlier this year. In Brazil, economists have increased their 2010 inflation forecasts for six straight weeks, according to the central bank. Investors may want to consider some protection.

There are three main sources of inflationary pressure: first, commodity prices. The United Nations’ Food and Agriculture Organization’s food price index is at its highest since August 2008, driven by gains in cereals. This has a big impact on emerging-market inflation: in emerging Asia, food accounts for 40% of the average CPI basket.

Second, emerging market efforts to prevent currency appreciation may prove inflationary. The cost of sterilizing currency market interventions—issuing bonds to mop up excess local currency—has become very costly given the extremely low yields on U.S. bonds relative to local-currency debt. That raises the risk of unsterilized interventions, leading to inflationary increases in the money supply. Meanwhile, emerging-market central banks may also hold off on rate hikes for fear of acting as a magnet for capital flows.

Third, emerging-market output gaps are closing and labor markets may be tightening. Many countries are quickly making up for the loss of growth in 2009; in India and China, in fact, there was only a modest slowdown. In Brazil, average wages rose more than 11% in September, or just over 6% in real terms, HSBC Global Asset Management notes; in Korea, Poland and Chile, the unemployment rate has fallen to previous cycle norms.

How can investors protect themselves? One option is inflation-linked bonds, although liquidity in emerging-market issues is relatively low. Breakeven inflation rates in countries such as Brazil, Turkey and South Korea show investors may be under-pricing the risk of higher inflation. Emerging market property and consumer stocks could offer an attractive hedge against inflation, particularly given growing domestic demand. As investors plow cash into emerging markets, a little insurance could come in handy.

Write to Richard Barley at richard.barley@dowjones.com