The most interesting development in global economics last week was the jump in commodity prices. With the world debating whether the US has entered into an economic recession or not, it was incredible to see commodity prices leap to new heights. Brad Setser had a timely entry in his blog on what united the public in the US, China and Saudi Arabia (www.rgemonitor.com/blog/setser/245470).
A significant part of the population in all three countries is worried about making ends meet.
A recent Pew attitude survey finds that 79% of the Americans think prices have risen a lot in the last five years compared with only 63% who thought so in 2001. Prices are considered by many as the most important problem facing the nation and 58% of the survey respondents, compared with 46% in January 2006, said their incomes were falling behind the cost of living. Economic data vindicated their concerns. Consumer price inflation was 4.3% in January and even the so-called core inflation rate (that excludes food and energy) was 2.5%, well above the 2% rate of inflation that the Federal Reserve considers tolerable.
In its latest quarterly economic projections, the Federal Reserve has raised the forecast for inflation and lowered the forecast for growth in 2008. Yet, it said that inflation expectations among the public appeared contained. But then, the American treasury secretary and the Federal Reserve chairman thought the problems in the housing sector would be contained, too!
The Federal Reserve sets much store by the inflation expectations implied by the bond market. While that may not have increased much, the five-year break-even inflation rate based on the yield difference between five-year nominal and inflation indexed treasurys has risen by more than half a percentage point since the Federal Reserve began cutting interest rates in August.
The logic of divining inflation expectations from the bond market is questionable when bond prices do not reflect views of private market participants any more, dominated as they are by international public sector buyers such as central banks. Inflation expectations are better gleaned from the huge run-up in commodity prices.
This is the first time in a couple of decades that the CRB Index of commodities prices is rising when the Federal Reserve is well into its monetary policy easing. In the past, the index had mostly dropped significantly or remained flat. A comparison between crude oil futures contracts now and six months ago seems to show they refer to price expectations in different planets. Now, the futures market expects crude oil prices up to 2016 to stay above $90 per barrel. Just six months ago, the contracts showed that crude oil prices would stay below $70 per barrel up to 2016. We are in a different world with respect to price pressures.
Policymakers are in a dilemma. Growth in Asia has not exactly fallen off the cliff yet, partly because it has not yet fallen off the cliff in the US itself. Therefore, they do not have a case to cut interest rates. At the same time, they dread raising rates to combat inflation for they fear that they would be dealing a deathblow to economic growth rather than inflation, by doing so. Consequently, they are pushed to a state of inactivity even as inflation keeps rising.
China has had a large role to play in the emergence of global inflation pressures. One source is its growth model with excessive dependence on consumption of raw materials and the second is its policy of accumulation of foreign exchange reserves. The latter helped to keep a lid on interest rates for longer maturities in America, encouraged booms in mortgage loans and home prices and, thus, facilitated consumption based on home equity extraction. Naturally, this contributed to rising demand for crude oil and elevated prices. Now, the chickens are coming home to roost.
China finds itself, too, in an inflation quandary. Inflation rates are high and rising. It is no longer possible to ignore this by attributing it to rising food prices alone. As for bottling it in, the fear is that the genie has already left the bottle. After the release of the inflation data for January, China Daily wrote an editorial urging that growth be sacrificed and inflation be tamed. This signals divergence of opinion within the country on the appropriate policy response.
A quarter-century of low and falling inflation has ended. The era of rising inflation has just commenced. That is why in recent weeks the price of gold is rising regardless of the fortunes of the US dollar, which is not too bright in any case. Gold sceptics should be happy to note that it is still early days to buy the metal, for the inflation genie has just started to fly.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer and Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org