Inflation titans marshalling 2011 forces

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By Cees Bruggemans, Chief Economist of FNB.

Having dipped as low as 3.2%, CPI inflation has already been rising for two months back to 3.6%, with forecasts of 4.5% this year and 5.5% next year.

This, though, is a ‘risk-free’ scenario, discounting some base effects boosting inflation higher in 2011, and assuming a ‘neutral’ Rand above 7:$ and 9:€, mostly ‘benign’ food inflation as good harvests have created protective buffer stocks (and the summer rains being most promising for continuing repeats, dam levels gratifyingly high, despite damage incurred), public charging continuing as tax source of last resort but baked into the cake, and labour pricing itself modestly out of real jobs (with job losses and productivity gains the usual shock absorbers, preventing unit labour costs from rising excessively).

Right, but what if?

What if labour keeps confusing nominal with real demands? Will society keep polarising between fewer survivors in formal employment, unionised and non-unionised, with the remainder forced into state subsistence?

Are these going to be the Three Pillars (thinking Chinese new-speak thought) of our New Society?

This fearful prospect provides its own answer in ongoing job losses and greater productivity gains, technology assisted (especially in labour-intensive services), with the state (meaning taxpayers) employer of last resort and welfare support.

Then also, we keep on humming about the ‘developmental’ state we are supposedly creating, but reality seems to be coming close to turning us into a ‘parasitical’ state, its sustainability a source of wonder for those so engaged.

What else should we really be concerned about when it comes to inflation prospects?

Globally, there are two candidates.

Firstly, negative output gaps turning positive in many emerging markets (high resource slack increasingly making way for overheating cost-push shortages).

Secondly, commodity price explosions (primarily agriculture, secondarily energy and some metals, and lastly industrial intermediate prices).

Some emerging markets and commodity producers have had a good recession and/or recovery, cyclically closing their output gaps, modestly boosting inflation prospects.

This is far from being a global phenomenon yet, thinking US, Europe and Japan, but also industrial China. Still, in some regions this already features and leads the global inflation cycle this decade.

Greater concern focuses on commodities. Intermediate industrial goods prices may not be a major source of new inflationary pressure soon due to much slack, but energy (oil), some metals (copper) and especially agricultural commodities are another matter.

Especially so where the new resource nationalism is most developed, whether rationing oil supply, rare metals or putting bans on agriculture exports due to poor harvests and resulting low inventory buffers. It reminds of overheated cyclical endgames in 2007-2008.

Endgames? But the new cycle is barely 18 months old? A cyclical endgame should take years to develop?

Tell it to the new global nationalists. Time was that freewheeling business titans gave young capitalism a bad name, but that’s 140 years ago. Today’s rapacious state monopolists are as good in squeezing global consumers for what they are worth.

High Asian demand growth driven by its explosive middle class expansion and constrained global supply conditions in many commodities are simply triggering old-fashioned price rationing.

Only Mother Nature could short-circuit this by deluging us with serial record harvests overfilling global buffers, but so far no sign, though ‘backwardation’ is noted (some forward prices lower than spot as future demand/supply looks better).

During 2H2010 agricultural price increases were already explosive, and more may be seen in 2011, steeply boosting inflation prospects in especially poorer country importers with high food components in inflation baskets.

South Africa, as food exporter, non-interventionist, great buffers and good seasonal rains may be saved from the worst initial stirrings here. But for how long?

Remember, our previous inflation upswing in 2006 also had major oil and food ingredients.

Oil has seen $70 but is now flirting with $100, while global food prices are sending warning signals of a violently turning tide.

Our GDP growth may remain modest near 3%-3.5%, held back by underperformance in state and private fixed investment, assisted by sector-specific constraints (electricity, credit, Rand). So our still large output gap and its anti-inflation effect may not disappear soon.

In contrast, the commodity universe could provide us again with early inflation boosts. Industrial goods prices and agricultural commodities may not be early harbingers (hopefully), but energy probably will be.

This leaves one other buffer, the overvalued Rand, preventing commodity shocks from spilling into inflation.

The unnerving requirement here is for the Rand to keep firming to match newly reviving commodity prices. Being already substantially overvalued through 2010, one wonders how much of a safety valve this could still be.

Though Rand firming proceeded smartly in December, January has so far provided a pullback towards 6.90:$ and 9.20:€. Will such pullbacks set a new course to even lower levels, or will renewed firming materialize, keeping commodity price impulses contained?

The cycle is young, the world willing and our Rand probably unable to keep this werewolf from the door forever, like repeats of 2005-2008. Eventually our inflation could also break higher.

Source: Cees Bruggemans, FNB, January 17, 2011.

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