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.

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U.S. inflation: Further significant declines expected

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Year-on-year growth in U.S. consumer prices fell to 3.6% in October from 3.9% in September. Due to its significant contribution of 32% to the overall CPI, shelter continues to keep the CPI in check with its year-on-year gain of 1.8%. The CPI excluding shelter fell to 4.4% in October from 5% in September on a year-ago basis. I was not surprised, though. More than 90% of the change in the CPI ex shelter with a one-month lag can be attributed to the year-on-year absolute change in the price of crude oil as represented by Light Louisiana Sweet.

Sources: I-Net Bridge; FRED; Plexus Asset Management.

The change in the oil price from a year ago indicates that the CPI ex shelter is likely to fall further to the 3.8–4% region in November. Assuming that growth in the shelter PMI remains unchanged at 1.8%, it means the overall CPI is likely to be in the vicinity of 3.2%, marking the lowest year-on-year growth since April this year. It will mean that in November the CPI will plunge by 0.27% from October – the largest decline since November 2008.

Producer price inflation is also rolling over. The change in the price of crude oil from a year ago indicates a further drop in the year-on-year growth rate of the PPI in November and December to approximately 5.5% is on the cards. That compares with 6.1% in October and 7% in September.

Sources: I-Net Bridge; FRED; Plexus Asset Management.

I expect year-on-year growth in both CPI and PPI to moderate further to 2% and 3% respectively in the first quarter of 2012 should the oil price remain unchanged at current levels. I do not think the FOMC will be concerned about slowing inflation as real disposable income will benefit substantially. An abrupt decline in both these gauges is unlikely unless the oil price falls out of bed. A sharp drop in the oil price will indicate global demand is falling and will in any event result in the FOMC acting aggressively.

Furthermore, I expect the growth rate of the core CPI to accelerate as its honeymoon resulting from a weak shelter CPI (contributing approximately 38% to the core CPI) is over as the latter’s growth on a year-ago basis is catching up with the growth in other components of the index.

Sources: I-Net Bridge; FRED; Plexus Asset Management.

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Historian Adam Fergusson on Weimar inflation and more

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In the latest GoldMoney interview, the historian Adam Fergusson, author of the definitive account of the Weimar inflation, “When Money Dies,” discusses with GoldMoney founder James Turk how inflation destroyed the German economy, corrupted German society in the 1920s, and how that experience may relate to the inflationary solution for governments today. The interview is 35 minutes long.

Source: GoldMoney (via YouTube), October 30, 2011.

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Inflation targeting in a rising inflationary environment

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The article below comes courtesy of Central Bank News, an authoritative source on monetary policy developments.

This report outlines where inflation is tracking in countries where the central bank has an inflation target. Central Bank News has compiled a table of countries/central banks that have publicly announced an official inflation target. In some cases the target is a government target, but in many cases it is one of the central bank’s key performance indicators. Of the 32 countries that Central Bank News is monitoring, which have inflation targets; 24 last reported inflation above target, 1 had inflation below target, and 7 reported inflation within their target range. Note, the inflation figures in the table below are all on a headline, or gross, inflation basis.

Of those that saw inflation above target, the standouts were Serbia (14.7% in April-11 vs target range 3.5-6.5%), Georgia (13.5% in April-11 vs target of 6%), Romania (8.4% in May-11 vs target range 2-4%), and Armenia (9% in May-11 vs target 5.5%). Below target was Japan (0.3% in May-11 vs target 1%), which only just emerged from deflation on a headline inflation basis. Of the 7 countries with inflation at target, or within their target range, 5 were also on target at the end of 2010, while 2 were above target.

The chart below shows the change in inflation versus target, between the most recently reported inflation figures and the end of 2010 inflation figures (from the IMF). Of the 32 countries, 23 saw inflation go above target, or go higher above target, 4 saw inflation falling closer to target (2 fell into target range), while 5 saw inflation staying within target.

So one of the key highlights of this report is that most countries saw inflation increasing compared to their target. This is consistent with trends observed in another Central Bank News report on interest rate adjustments, where of 79 central banks covered, 32 made net increases to interest rates. Central bankers in most countries have had to work harder this year to contain inflationary pressures. However there also remains a core of countries with low inflation pressures, which helps explain the 40 central banks that made no net changes to interest rates in the first half of the year.

Much of the increase in inflationary pressures can be linked to the recent surge in commodity prices, with agricultural commodities driven up by structural pressures such as rising populations, and a string of adverse weather conditions which have impacted on supply. Energy prices have also been surging as cyclical pressures and geopolitical tensions have impacted on oil prices.

Another factor has been relatively strong aggregate demand in emerging markets, with 18 of the 24 countries with inflation above target being emerging markets. Indeed most emerging markets have reported stronger GDP growth through the global economic recovery than their developed market counterparts, with many seeing the risk of overheating rising above the risk of maintaining growth. One thing for certain is that the growth vs inflation balance will become more complex during the second half of the year.

What is inflation targeting?
Inflation targeting is an often cited goal of monetary policy, alongside other goals such as maximizing GDP growth, optimal employment, and financial stability. While there is some debate about the merits of inflation targeting, the benefits often cited of explicit inflation targeting include greater certainty and transparency of central bank interest rate decisions, price stability, and ultimately a lower neutral interest rate, provided inflation can be contained within a reasonable range. See the Wikipedia entry on inflation targeting for a summary of the issues and debate on explicit inflation targeting in monetary policy.

Source: Central Bank News, July 9, 2011.

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Emerging economies – short-term gain, longer-term pain?

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This post is a guest contribution by Manoj Pradhan of Morgan Stanley.

Rather than signaling an extended period of tightening, China’s latest policy rate hike is expected to be the last of its kind in 2011. In a similar vein, policy headwinds to growth are set to ease in AXJ and LatAm, setting up the stage nicely for a rebound in risk sentiment. Even though most of the policy normalisation is ahead of us in the CEEMEA region, the overall change in sentiment should help here as well. Slowing EM growth will take some of the wind out of the sails of inflation and base effects will kick in over the next 3-4 months to push headline inflation lower, in our view. A macro environment where policy isn’t tightening further, inflation is on the decline and GDP growth is close to trend should be a potent combination for a recovery for risky assets. A final trigger for this change is the prospect for a better 2H in the US that our US team expects.

However, on a longer horizon, EM central banks don’t appear to have dealt with inflation conclusively. Risks to growth and particularly to inflation are to the upside. The ongoing inflation episode starred commodity prices while core inflation stayed benign almost everywhere. The next inflation story is likely to have core inflation in the driver’s seat. Central banks would then likely have to respond with another round of tightening. But this is a story for 2012, not 2011.

It should be noted that inflation in 2012 need not be of a rampant kind or even of a variety that central bankers will not be able to tame. Simply put, the return of EM inflation in 2012 is a risk, which implies that monetary policy tightening could also return. Until we get there, risky assets are likely to remain buoyant in the benign macro environment. In this note, we pay more attention to factors that could lead inflation higher, directing readers to our colleague Chetan Ahya’s note (Asia-Pacific Economics: Nearing the End of Rate Hike Cycle, June 30, 2011) for a detailed analysis surrounding the end of policy normalisation by AXJ central banks.

A Better Macro Environment Should Mean a Return to Risk

Inflation is set to fall in 2H11 in most of the EM economies we cover. We have argued in the past that moderate levels of inflation that most EM economies have at the moment are not a direct threat to economic growth. It is the actions of policy-makers who want to prevent inflation from rising that inflict damage on growth. If they didn’t act, inflation would likely rise to levels where it would directly hurt growth. To add insult to injury, policy-makers would have to then act even more aggressively to bring rampant inflation under control.

Oil and food inflation, which sparked the inflation scare, have been falling across the EM world. More importantly, growth is slowing to trend without a hard landing on the cards. Prima facie, there appears to be little reason for monetary policy to stay restrictive. And indeed, AXJ and LatAm central banks are close to completing the hikes they have in the pipeline for this episode. CEEMEA monetary policy was late to start rate hikes, given that the region’s economic growth lagged the other EM regions and most of the policy normalisation is therefore still ahead of us.

By that rationale, the fall in inflation – thanks in part to the growth slowdown – is likely to satisfy policy-makers and hence keep policy from getting tighter than it already is. Brazil’s monetary policy is the only one set to forge into outright restrictive territory and Turkey is likely to flirt with this boundary. However, in China and India – the other two economies where monetary policy is slightly restrictive – monetary policy is set to ease from its current slightly restrictive stance to a neutral one. In China, the policy stance could well ease over the summer and in India around six months down the line. This should set the stage nicely for a return to risk.

Caveat Emptor – The Second Coming of EMflation…in 2012

However, something will eventually have to give from the combination of falling inflation, economic growth at trend and policy rates on hold. Not just because it always does, but also because we argue that EM policy-makers, fully cognisant of the risks to US and global growth, have not been aggressive enough to put a more lasting dent in inflation. Our simple argument in this note is that, if these risks abate, and our economics teams expect them to, then the cyclical risks to EM growth and particularly to inflation are to the upside.

A familiar side-effect of better-quality global growth is higher commodity prices. However, unlike the 1H11 episode of EM inflation, it is not commodity shocks that are central to our argument here. Rather, it is that policy on hold and growth at trend render the EM world susceptible to upside risks, as we discuss below.

In addition to the cyclical arguments, structural drivers should keep inflation risks to the upside. Rather interestingly, the structural issues are set up such that EM inflation can rise even without an increase in the current level of EM growth.

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Inflation: U.S. Consumer Price Index to drop in June

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The US consumer price index rose significantly to 3.44% in May from a year ago and 0.2% from its April level. The increase was bang on target with my estimate. However, I believe that May’s figure on a year-ago basis approached a plateau in the current cycle.

My analysis indicates that changes in the CPI inflation rate on a year-ago basis and especially CPI ex shelter are explained by changes in the oil price compared to a year ago. It is particularly evident since the end of 2006 where more than 94% of the direction of the CPI ex shelter is explained by the year-on-year absolute change in the price of crude oil.

Sources: I-Net Bridge; Plexus Asset Management.

Shelter’s weight of approximately 32.3% in the CPI and the one-month lag between the change in the oil price and CPI ex shelter inflation enables me to make a reasonably accurate forecast. The change in the oil price is a known factor while the only unknown factor is the shelter CPI. But with a more stable trend the shelter CPI inflation rate that can be expected is fairly reasonably assumed.

Sources: Bureau of Labor; Plexus Asset Management.

The year-on-year change in Light Louisiana Sweet crude in May was $41.53 per barrel. The historical relationship between the change in the Light Louisiana Sweet crude and the CPI ex shelter inflation rate points to a year-on-year CPI ex shelter inflation rate of 4.77% in June given the said lag. That makes up 67.7% of the overall CPI inflation rate (overall CPI minus the 32.3% weight of the shelter CPI) and will therefore be 3.23%. If I assume a year-on-year change of 1% in the shelter CPI, May’s total CPI will add up as follows:

(67.7% of 4.77%) plus (32.3% of 1%) = 3.23% plus 0.32% = 3.55%.

The 3.55% inflation rate means that the consumer price index will drop by 0.1% in June. The first decline since June last year!

But where is CPI inflation heading?

Without taking a stab at where the oil price is heading, I looked at three scenarios where the price per barrel of Louisiana Sweet crude was kept constant at $100, $115 (current) and $130 respectively for the next 12 months. The monthly oil price was then compared to the price a year ago and depicted against the CPI ex shelter inflation rate lagged by one month.

Sources: Bureau of Labor; I-Net; Plexus Asset Management.

By applying the historical regression equation the trend of future CPI ex shelter year-on-year inflation is as follows:

Sources: Bureau of Labor; I-Net; Plexus Asset Management.

Assuming that the year-on-year inflation rate for shelter remains steady at 1.0%, the outlook for the overall CPI inflation rate is as follows:

Sources: Bureau of Labor; I-Net; Plexus Asset Management.

Year-on-year CPI inflation 

Rate %

@ constant $115/barrel@ constant $130/barrel @ constant $100/barrel
May-113.44 (actual)
Jun-113.553.553.55
Jul-113.324.032.61
Aug-113.153.862.44
Sep-113.444.152.73
Oct-113.013.722.30
Nov-113.023.732.31
Dec-112.853.562.14
Jan-122.513.221.80
Feb-122.112.821.40
Mar-121.552.260.84
Apr-121.352.060.64

Sources: Bureau of Labor; I-Net; Plexus Asset Management.

It is evident in the above that the US CPI inflation rate is likely to peak at 3.55% in June if the oil price maintains its current level or weaken. Even if the oil price spikes to $130 per barrel and maintains that level, the inflation rate will still top out in July this year. There may be a short further spike in September owing to a brief drop in the oil price in August last year.

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