Inflation has returned; its impact on the housing market is apparent. To make matters worse, emerging markets - a major cause of inflation - are unlikely to change course. Véronique Riches-Flores reports
Credit bubbles simultaneously exacerbate inflation and deflation risks. In essence, too much liquidity creates an excess of money relative to goods and assets, and an excess of credit growth compared with revenues.Such situations usually occur when, for whatever reason, inflation is absent or subdued, making asset prices the first beneficiaries of excess money. The resulting overvaluing of asset prices in turn has a positive impact on economic growth. This eventually feeds into an economic cyclical upturn that progressively assists in lifting cyclical inflation. At this point, excess liquidity becomes more inflationary as asset prices and the real economy feed off each other. However, this never usually lasts for long.
Goods price inflation then soaks up liquidity from asset investments and interest rates respond to higher inflation. The risk of an abrupt correction in asset prices is then at its maximum, threatening the economy with deflation.At this stage, people concerned with the risk of asset price deflation neglect the inflationary risks; hence the ability of policymakers to fight inflation is seriously damaged; withdrawing excess liquidity to deal with the inflationary pressures would create conditions ideal for major financial shocks.
The situation can be summarised as follows: the bigger the asset price bubble, the greater the efforts from policymakers to fight deflation instead of inflation. If the policy response eventually succeeds in eradicating the risks relating to asset prices and those associated with growth, it is a good bet that inflation will persist. This is the central bankers' dilemma today.
The great comeback of inflation…
Years of too much liquidity and above-trend growth in the global economy have put an end to two decades of disinflation. During the past two years, inflation has run out of control in every economic bloc globally. World inflation averaged 3.5% per annum between 2001 and 2007; it has now climbed above 7%, its highest level since 1996. Although the post credit bubble period contains major systemic risks that could still reverse this upward trend, inflationary pressures are clearly dominating the world economy. This is likely to remain the case until global growth at least eases significantly below trend and maybe for even longer.
Years of very loose monetary conditions all around the world are largely responsible for the current situation. In the absence of inflation, monetary policies all over the world have largely favoured credit-driven growth during the past decade. This has compensated for weak economic conditions in western economies and further supported the ‘catch-up' process in emerging countries. Cheap credit and loose financing conditions counteracted the negative backdrop of the return of unemployment in the US and across Europe. Ratios of debt to GDP soared well above their long-term trend during the past 10 years, with debt all over the western world fuelling housing bubbles. In the US today, overall private sector debt is some 20% above its trend. Deviations from trend have also been exceptional in European economies (including most euro-zone countries, the UK and Scandinavia), the only exception being Germany.
Extremely accommodative monetary conditions in emerging markets also created the conditions for these economies' spectacular recent growth. In China, where interest rates have been well below nominal GDP growth for years, the credit explosion has been the key driver of growth. In turn, this provided an exceptional boost to the world economy and even looser rate conditions through recycling the Chinese surplus into western bond markets, especially those in the US.
Surging commodity and food prices
The closing of the gap between emerging market economies and those in the developed world has been a major source of increased demand for all kinds of commodities. Global demand for oil has surged by 15-20% in the past 10 years, of which 90% can be attributed to emerging markets. Demand for steel has risen by 60% over the same period, nearly 40% of which is attributable to China itself. This pattern can be found in the strong demand growth rates enjoyed by most commodities in the past decade. The commodity boom is certainly not over. World demand for energy should increase by at least 75% by 2050, according to the expected growth in the global population and economic growth rates in emerging countries for this period. The current known potential global energy supplies are very unlikely to keep up with this surge in demand. Soaring commodity prices have been the first symptom of these abnormal and largely unsustainable economic conditions.
The surge in commodity prices was initially easily absorbed by the deflationary effects of increased productivity in emerging countries and more competition in the world economy. This situation gradually changed once wages in emerging countries began catching up with those in developed economies; output gaps in the western world started shrinking; and soft commodities entered an inflationary spiral after years of relative decline compared with other commodities.
Food is a large portion of consumer spending (15% in developed economies but 40% in BRIC economies). The transmission mechanism of higher food prices to wages is particularly powerful, especially when the economy is booming. The surge in food prices adds a political dimension to economic constraints, creating strong incentives for governments in emerging countries to award high annual wage rises. This contributes to accelerating production costs where productivity gains do not match wage gains any more. In the global economy, this outcome quickly translates into higher prices.
Recent changes in international ex-energy trade prices leave no room for doubt: the long-lasting disinflation of international prices is over. Import prices, as with exports, are rising across the board for all regions and products. The US imports inflation from all kinds of goods, both consumer and investment goods. But it also exports inflation to the rest of the world.
While it is tempting to regard this change as an effect of the falling dollar, trends in other regions hardly support this. European countries are also importing inflation despite the surge in the euro this year. For instance, euro-zone prices of imported Chinese products have increased by more than 10% year on year since the beginning of 2008. Interestingly, however, it is in intra-Asian trade prices that the first evidence of inflation emerged many quarters ago and, by the way, the first signals of a likely return of global inflation.
Rising costs in emerging countries and consecutive rises in international prices of trade seriously dampen global competition. This increases considerably the probability that inflation will spread into developed economies. Soaring profits in the value-added segment have been one of the major consequences of the high level of competition that characterised the past 15 years. Reduced competition could generate the opposite effect by opening the doo r for a rebalancing in wages/profit sharing. This implies higher inflation in the western world too.
If this analysis is right, inflation in the developed world could eventually decouple itself from the output gap and become largely dependent on inflation in the rest of the world.
And the weakness of inflation-fighting tools
The prospect of higher global inflation rates calls for very aggressive policies against inflation. Central banks should remove excess liquidity rapidly, raise interest rates and encourage the appreciation of their currencies. Although we all know the right responses to fight inflation, reality is often more complex.
First, the tightening of monetary conditions while the debt deleveraging process is in place would considerably damage growth and the financial system. The banking crisis is not over, as news from the sector keeps reminding us. Tightening liquidity conditions at this point would no doubt deepen the underlying systemic crisis around the world.
Second, inflation-countering policies need to be shared by a large majority of countries. With emerging countries now contributing half of the world GDP and being the first source of inflation, their role in the global action against inflation is central. Will they participate actively to achieve this goal? We doubt it, as fighting inflation would simply mean an abrupt end to their ‘catch-up' process in order to break structural upward pressures on prices. China is naturally at the centre of this game. Will it do what is necessary to stop the strong growth in wages it has experienced? The answer is far from evident.
The social and political risks associated with monetary tightening are substantial in emerging countries. This is true for China as it is for others and tends to make officials slower in taking the right policy decision. The most recent temptation for Chinese authorities to redefine the official calculation of inflation is a nice illustration of how the problem is being addressed. But this is not the only difficulty. The Chinese economy has also largely participated in the credit bubble and the country is far from immune to a possible financial crash. The short-term cost of fighting inflation is considerable and probably seen by many as much higher than the cost of inflation itself.
All in all, central banks will probably face many difficulties in preventing inflation in coming years. Hiking rates in the US, Europe or even China is highly risky from a financial point of view. Do policymakers have any solution other than to hope for a substantial drop in global growth to curb inflation? Probably not. Even a lasting drop in oil and commodity prices is likely to have only a temporary disinflationary effect as it could be followed by a major global growth - precisely what policymakers do not want.
The probability of sustained high inflation in the medium term seems high. If this is confirmed, great uncertainty will inevitably persist. After two decades of disinflation, central banks' reaction to inflation is very difficult to predict. With inflation back on the agenda, countries facing structural imbalances (large deficits) might pay a high cost if their policy appears to be behind the inflation curve. Severe exchange rate crises have always accompanied inflation. Growth will also suffer around the world eventually. Western economies are already facing a sharp slowdown because of significant increases in inflation. Emerging countries can hardly avoid the cost of inflation on future growth.
The inflation cost of the global credit bubble is no doubt substantial. However, the good thing is that inflation will trigger the absorption of excessive debt. By increasing nominal income growth, inflation will alleviate the world economy from its excessive debt burden. This is certainly a less painful adjustment for the world economy than a long-lasting adjustment on credit. It also makes the deleveraging process less painful for asset prices.
For instance, in the post housing bubble period of the mid-1970s the surge in inflation made most of the downward adjustment in real housing prices. This prevented a major correction in nominal prices and prevented a surge in mortgage defaults. However, the current situation is not fully comparable. Inflation is back but wage growth remains subdued and it will obviously take time before any rebalancing in wage/profit sharing offsets the negative impact of slowing economic growth on wage trends.
The housing market correction in most developed economies has so far been amplified rather than smoothed by the comeback of inflation. The situation might be different in developing countries where wage inflation has taken off and where banks have so far been rather protected from the current financial crisis. The negative real interest rates that are usually in place in developing economies have certainly more chance of continuing to provide support for housing investments in these countries than in developed economies. Here, conditions seem much closer to those dominating the industrialised world in the 1970s.
Véronique Riches-Flores chief economist Europe, Societe Générale Corporate and Investment Banking