Global inflation: Merry-go-round spinning again?

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This post is a guest contribution by Spyros Andreopoulos of Morgan Stanley.

The Great Monetary Easing (Part 2), is in full swing… In response to a slowing global economy and further downside risks emanating from the possibility of an escalating Eurozone debt crisis, central banks all over the world – and across the DM-EM divide – have been deploying their arsenal for a while now, and should continue to do so. The result is aggressive monetary easing on a global scale – what we have dubbed the Great Monetary Easing, Part 2 (GME2; see Sunday Start: What Next in the Global Economy, January 22, 2012); this follows on from GME1 in 2009-10. The GME2 is now in full swing. Last week, the Bank of England announced a further £ 50 billion of gilts purchases, to take place over the next three months. On Tuesday, the Bank of Japan upped the target of its Asset Purchase Program by 50%, from JPY 20 trillion to JPY 30 trillion, with the increment concentrated exclusively on JGB purchases. We think Sweden’s Riksbank will pick up the baton from the Bank of Japan on Thursday and cut the repo rate by 25bp.

…reaching its crescendo in 2Q, when the heavyweights should re-join in the action.

Fed: Nurturing the green shoots. In contrast to previous cases where monetary stimulus was reactive to a weakening in the economy, we think the Fed will embark on a further round of asset purchases despite the recent data improvement (see US Economics: Fed Thoughts for 2012: Into the Heart of Darkness, December 27, 2011). The aim is to “nurture the green shoots” – support the (weak) recovery as it unfolds rather than allow it to flag again.

ECB: Activating the circuit breaker. Liquidity provision, past and forthcoming (there is one more 3-year LTRO on February 29), has so far turned the vicious circle of a run on banks and peripheral sovereigns into a virtuous one. However, we are not convinced that liquidity provision will be enough to act as a circuit breaker; hence, we think that the ECB will have to embark on broad based asset purchases of private and public sector assets – but only after taking the refi rate to a new historical low of 0.50%.

Out of a total of 33 central banks under our coverage, 16 have eased policy in various ways since 4Q11; 7 out of 10 DM central banks and 9 out of 23 EM central banks. Many of these central banks will ease further, on our forecasts, while the central banks of Poland, Korea, Malaysia and Mexico, which have not cut so far, will also join in (and the National Bank of Hungary will likely reverse its 100bp of hikes over the course of the year).

Meanwhile, in the real economy… The data of late have generally been characterised by regional divergence. The US had a relatively good 4Q11 (growth was at the upper end of the 1-3% channel that our US colleagues have identified), while the euro area contracted over the same period. Chinese data still look consistent with a soft landing. More broadly, high-frequency activity indicators such as the various Purchasing Managers Indices are consistent with some pick-up in activity across the globe. That is, the global economy may, on the whole, be continuing on the recovery path after what might prove a mid-cycle slowdown.

Benign base case inflation forecast but upside risks… What does all this mean for the global inflation outlook? Our current inflation forecasts give no cause for concern – we expect inflation to remain benign due to past economic weakness and favourable base effects from the previous commodity price run-up. So what’s the issue?

• First, the Fed’s “nurture the green shoots” maxim implies that the FOMC will be putting the pedal to the metal for almost any reasonable data outturn over the coming months. Other central banks may respond in the same way and press on regardless – or feel compelled to do so due to action by the Fed and the other major G10 central banks. If the current data upside proves sustainable in the sense of representing a genuine cyclical improvement, central banks may end up easing into an already strengthening economy – generating cyclical inflation pressures further down the line. In EM, these would be added to structural pressures which, rather than having gone away, have merely been masked by the softening economy (see QE – What’s Different This Time? February 8, 2012).

• Second, if – contrary to our expectations – global growth shifts up a gear, say because of a sustained and vigorous improvement in the US labour market or favourable developments on the Eurozone crisis front (which would bring us closer to our bull case for global growth of 4.2% for this year), the global central bank may again have administered too large a dose of monetary stimulus.

• Third, our inflation forecasts are based on the assumption that oil prices follow the futures curve. However, if QE does push up the price of oil and other commodities from here, our current forecasts will turn out to be too low.

2013 like 2011? The risks to inflation thus look skewed to the upside. Throw commodity prices into the mix – already meaningfully higher recently and the script becomes familiar – reminiscent of the inflation run-up that materialized between 3Q10 and 3Q11: DM easing, EM overheating, higher commodity prices, and all round rising inflation pressures. Our AXJ economist Chetan Ahya is already flagging upside risks to Asian inflation emanating from the forthcoming DM monetary easing (see Asia Pacific ex-Japan Macro Dashboard, February 13, 2012). Indeed, we think the entire global economy could be headed for yet another run-up in inflation – probably becoming visible late this year but unfolding mostly in 2013.

The Merry-Go-Round is alive and well… That’s because conditions remain in place for yet another loop on the Global Inflation Merry-Go-Round – a mechanism we highlighted early last year (see The Inflation Merry-Go-Round, January 26, 2011).

1. Super-expansionary monetary policy in the major developed economies, particularly the US, a) contributes to commodity inflation, and b) is imported by EM central banks through (US dollar) soft and hard pegs.

2. Price pressures rise in EM due to domestic overheating and higher commodity prices. Inflation is then re-exported to DM through more expensive goods exports.

3. More expensive imports from EM and dearer commodities raise inflation in DM. In turn, DM central banks initiate the next round by maintaining – or increasing – monetary accommodation if the economy remains weak (possibly due to the double-whammy imported cost shock).

…as long as EM sticks to its US dollar quasi-pegs. Note that EM currency policy is crucial for the Merry-Go-Round. If, and to the extent that, EM economies allow their currencies to appreciate against the dollar – most likely in order to shield themselves from higher commodity prices in dollar terms – then the Merry-Go-Round is weakened. EM then ceases to import the Fed’s superexpansionary stance and thus avoids overheating while also mitigating the commodity price shock. The US – or indeed any economy embarking on expansionary monetary policy – will still suffer:

• a commodity price increase in domestic currency terms, as commodity producers are inclined to maintain the value of their exports in real terms,

• an increase in import prices as their currencies weaken against EM.

Conclusions. If the risks to the inflation outlook we sketch here materialize, it will likely have implications for the monetary policy outlook presented earlier. If inflation rises uncomfortably, some central banks – we think mainly in EM – will be forced back to the drawing board. Less easing and/or earlier tightening would likely be the consequence, as some central banks may attempt to get off the Merry-Go-Round. Stay tuned.

Source: Spyros Andreopoulos, Morgan Stanley, February 17, 2012.

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