Thursday, March 06, 2008

Inflation or deflation?

With the news that the BoE is to hold interest rates steady – a not unexpected decision – Ambrose Evans-Pritchard in back in The Daily Telegraph. This time, in a news piece, he is illustrating the current dispute on whether inflation or recession is the predominant economic hazard.

His piece is headed, "Inflation at seven-year high in OECD countries", the proximate cause, as always, being food and energy costs. These pushed inflation across the OECD club of rich countries to 3.5 percent in January, the highest level in seven years.

This we learn has led to a "heated dispute" among economists and central bankers, splitting the profession down the middle.

On the one hand, we have Albert Edwards, global strategist at Société Générale. He says the price scare would soon be a memory as the US downturn spreads to the rest of the world. "Commodities are a bubble on stilts," he adds. "Before the end of the year, commodity prices and emerging markets will be unravelling. We will see negative CPI inflation within 12 months across the developed world."

In the middle are the Federal Reserve's key trio of Ben Bernanke, Donald Kohn and Frederic Mishkin. They fear a milder version of this scenario, warning that the US housing crash and credit turmoil risk setting off a downward spiral.

The other end of the dispute is represented by Morgan Stanley's research team. They warn that central banks are letting the inflation genie out of the bottle across large parts of the global economy. "The culprit is global monetary policy. It is overly expansionary and likely to become even more so. Global inflation will continue to overshoot expectations in coming years. It's mostly structural," says Joachim Fels, the head of research.

His team is concerned that the powerful forces that had kept prices in check over the last generation have either burned out or turned foe. The efficiency gains from the internet and deregulation of the economy have already been pocketed. The pace of productivity gains in the US has slowed, leading to wage pressures instead.

Furthermore, they add, the "China effect" that held down the cost of manufactured goods in the 1990s has increasingly been offset by the commodity surge caused by booming industrial growth in Asia. A string of countries in Asia and the Middle East are effectively importing America's reflation policy through their dollar pegs, causing them to overheat.

Interestingly, we see from the AFP agency that Chinese Premier Wen Jiabao is elevating inflation to the top of his concerns.

Addressing the Chinese parliament (pictured - nothing more than a showcase for Wen’s annual statement), he also points to problems in the United States and elsewhere that were set to hurt China's economy. He is looking to slow growth to around eight percent this year, from 11.4 percent in 2007, and to keep consumer prices from rising more than 4.8 percent.

Crucially though he is admitting that the inflation goal would be tough to meet after 2007 saw the cost of food and other necessities soar, fuelling discontent with the government. Reinforcing the Stanley Morgan view, he notes that, "Because factors driving up prices are still at work, upward pressure on prices will remain great this year."

AFP notes that inflation is one of the most sensitive issues for China's Communist Party rulers, as the sharply rising cost of essentials have the potential to lead to social instability – we are back to the spectre of food riots again, with the daunting comment that, "The inflation issue is entirely a result of insufficient supply …".

That, in fact, is the key issue. In the standard economic model, a recession reduces demand which has a deflationary impact on commodities, driving down prices. But, while there are indeed massive deflationary pressures in the pipeline, the big test is whether shortage values will counterbalance the deflationary effect and buck the market, driving prices up.

One important factor to note is that China – which is most at risk politically from food and basic commodity shortages – has massive dollar reserves, set to approach $1.5 trillion this year, and is in a position therefore to bid high for scares stocks, and/or buy dominating interests in commodity supplies, thereby placing itself in the front of the queue when it comes to ensuring supplies.

Looking at the broader political situation in China, the main news section of The Telegraph reports that the government is bringing in price controls “to help poor”. Economically, of course, this is bad news as it disincentivises production, which can only add to the weather stresses on top of the structural constrains on production – particularly in the food sector. That the government should be resorting to such measures also reinforces the sense of crisis afflicting this huge nation, with a population of 1.3 billion.

One can sense something of this in an obvious "puff" from Xinhau extolling the meeting of "a number of grassroots policy consultants," including a rural teacher and a pig farmer, who were "excited to hear their proposals announced in Chinese Premier Wen Jiabao's government report".

For a more measured corrective, however, Ambrose has posted a long piece on his blog which rehearses the issue he raised on Monday. It takes the discussion forward, with some interesting comments – but, in truth, we are no better equipped to read the runes. One thing is for sure, though - the politicians do not seem to be part of the debate.


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