Global Inflation Scare: Overview
- With the global recovery strengthening and commodity prices rising sharply, inflation has returned as a market theme.
- In a series of research papers in the coming weeks, we will look at the global inflation theme from different angles and look more closely at the inflation outlook for different regions.
- We start out with an overview of global inflation trends and put it into a broader perspective.
- Commodities, rather than labour, are increasingly becoming the scarce resource in global production. Hence, we will probably continue to see low core inflation in the advanced countries while headline inflation will be harder to control. As we believe we are seeing a super-cycle in commodities with prices continuing to trend higher, this is a pattern that is likely to persist for some years.
- This has important implications for the monetary response across regions. Given ECB focus on headline inflation and Fed focus on core inflation, we would expect the ECB to hike rates before the Fed in this cycle, thus putting more upward pressure on European bond yields relative to US yields in the medium term.
- Rising food prices have the greatest impact on Emerging Markets as food is a larger share of the consumer basket. This will trigger more tightening of monetary policy in these markets during 2011.
Inflation rising on higher commodity prices
Commodity prices have once again increased significantly as the global recovery has led to price increases on metals and energy. Prices on soft commodities have been pushed sharply higher by rising demand and weather disturbances as the weather phenomenon La Niná has led to floods in parts of Asia, Australia and Brazil, while causing a dry spell in Argentina. This development bears a certain resemblance to the food price crisis during 2006-08. The CRB index is now up 86% from the bottom in early 2010. Measured in euros, the index has climbed 88%!
In 2008, the rise in commodity prices came to a sudden halt as the financial crisis led to an economic collapse worldwide. One could worry that prices this time could continue even higher. Any new weather disturbances could trigger a further sharp rises in soft commodities. So far, there are very few signs that price increases are about to stop.
We are already seeing the effect on inflation rates. In the euro area, inflation has risen above the ECB's upper limit of 2% and we expect it to stay above 2% for the rest of the year. In Emerging Markets, inflation has also increased significantly - especially due to higher food prices as food has a much higher share of the consumption basket in these countries. Inflation in China and India is currently running at 4.6% and 9.7%, respectively. So far, the US is the country least affected with inflation at 1.4%.
New inflation regime: Commodities is the bottle neck
It seems increasingly likely that we are entering a new inflation regime. For decades, we have been used to thinking of inflation in a country as being driven by the slack in the local economy as described by the output gap and unemployment rate. The speed limit is set by the natural unemployment rate and potential output in the specific country. When thinking of bottlenecks, we are used to thinking of domestic factors such as the resource of labour.
However, we have tended to ignore the fact that there are also resources needed for production that are not local in nature but something all countries compete for: commodities. This sets the speed limit for how fast the global economy can grow. How that growth is divided between countries depends on which countries can bear the higher costs of those commodity resources.
Commodity prices have for many years not been a scarce resource in production. And although creating volatility, prices have moved mostly sideways for decades (see chart). However, over the past 10 years, we have seen a rising trend in commodity prices. We believe we are witnessing a super-cycle in commodities in which prices will continue to trend higher. It may be that there are sufficient resources in the ground for the global economy for many years. But with the rapid pace of growth in Emerging Markets, the demand growth is simply outpacing supply growth, which is pushing prices higher.
Global growth becoming more commodity intensive
One important feature of global growth is that it is becoming more commodity intensive. Global growth is increasingly driven by Emerging Markets and less by advanced economies. One percentage point growth in these countries requires more commodities than one percentage point growth in advanced countries. Growth driven by infrastructure and industrial production is demanding more commodities than growth driven by the service sector.
Twenty years ago, growth in Emerging Markets only accounted for one-third of global growth while advanced countries accounted for two-thirds. Since then, the relationship has shifted significantly, with Emerging Markets now driving 75% of global growth and advanced countries only responsible for 25%.
The move in production to less energy-effective countries also implies higher overall energy consumption for a given level of global production. Producing motor bikes in China is for example less energy-effective than producing them in the US.
We expect continued strong growth in Emerging Markets for many years as, for example, China and (especially) India are still in the early stages of the catching-up process. The rising demand for commodities is thus likely to remain intact. We will elaborate further on the super-cycle for commodities in a separate research paper in which we also look at different scenarios for commodity prices.
Headline inflation higher while core inflation stays low
In the US and the euro area, the upward pressure on inflation from commodities will mainly be reflected in headline inflation. Core inflation is expected to be subdued for some time as we only see limited room for second round effects. With unemployment around 10% in both areas, wage pressures are very low. A price-wage spiral is unlikely, in our view, with bargaining power among employees being very low. There will probably be a small pass-through from higher commodity prices to consumer prices as input costs rise. But again pricing power is quite low so this effect will be of a limited magnitude as it is difficult to pass on costs to higher prices without damaging demand further.
Will rise in money supply lead to inflation?
An often mentioned concern is that the monetary expansion from central banks - not least the Fed - will lead to inflation. It is important to note however, that despite the QE from the Fed actual money growth hitting the economy is not growing very strongly. We therefore do not see an imminent risk to inflation from the loose monetary policy. While rising above 10% in early 2009 M2 growth in US has slowed significantly to currently around 3%. In the euro area M2 growth has slowed from more than 10% prior to the financial crisis to around 2% now. Hence although base money has increased, the credit multiplier has decreased and has kept the actual money growth subdued.
The same picture emerges when looking at credit growth. So far there are no signs that the expansionary monetary policy is leading to a strong credit expansion. On the contrary, credit growth is still very subdued in both the US and the euro area. So the money Fed and ECB are pumping out is more or less "dead money" as it is not used for financing new investment projects, housing activity or consumption.
There is a risk, though, that if - or when - the money becomes "active money" and feeds through to corporate and consumers through the credit channel, it could become inflationary. In this situation there will be a need for the central banks to withdraw the significant money expansion and raise interest rates. This is part of the reason why ECB is "permanently alert" as ECB president Jean-Claude Trichet expresses it continuously.
Different response in US and euro area
The mix of headline inflation on the high side while core inflation stays subdued will have an asymmetric reaction from the Fed and ECB. The Fed is focused on getting core inflation higher from the current low levels around 0.5% - way below its implicit target for core inflation around 2%. Hence the Fed will be patient before moving rates higher with unemployment very far from its objective of full employment.
On the other side of the Atlantic, ECB has an objective for headline inflation. ECB can accept inflation above its target as long as it expects it to be below 2% on its policy horizon, which is the medium term. However, ECB will be very sensitive to any signs of second round effects on wages or core prices. ECB will also watch inflation expectations very carefully. During ECB's history inflation forecasts have underestimated realised inflation again and again - exactly due to continued increases in commodity prices.
ECB will not react directly to inflation above its target if it is deemed temporary. But ECB may see a rising risk of second round effects earlier - all else equal - as the economy continues to recover during 2011.
The mix of headline inflation on the high side while core inflation is subdued is expected to lead ECB to hike rates before the Fed in this cycle. We thus still see the first hike from ECB in Q4 2011 while Fed is not expected to hike until 2012. This will be different from other cycles. But we are also in a new inflation regime in which commodity prices play a bigger role for inflation than seen historically.
Emerging Markets' inflation affected more
Emerging Markets are more severely hit by the rise in food prices as food is a much higher share of private consumption. In India for example food constitutes 57% of all private consumption. Hence inflation rates and purchasing power are taking a big hit from the current rise in food prices, which has in some places already caused social unrest. This is a major challenge for central banks and authorities in these countries.
However, part of the reason for the sharp rise in prices comes from a significant increase in demand from these markets themselves. Hence it leaves part of the job of solving it with the central banks in Emerging Markets. Real rates in most Asian countries are very low as they are reluctant to raise rates too much because it could lead to an even stronger inflow of hot money and appreciation pressure on their currencies. This leaves the clear danger of overheating as demand growth is moving above the speed limit of the economies.
The central banks in Asia have started to speed up rate increases to rein in inflation. Most recently, the central bank in Indonesia raised rates on 4 February after rates had been left unchanged since mid-2009 following a series of rate cuts.
The continued rise in commodity prices is likely to lead to further tightening in Asia during 2011.