Inflation vs growth: too hot, too cold, or both?

Inflation vs growth: too hot, too cold, or both?

As if the spectre of a US recession was not enough, the markets have been spooked recently by the return of that old ghoul, inflation. High inflation numbers in the US have sent the markets reeling, as they worry that the fear of stoking inflation would hold back central banks from reducing interest rates any further. Stagflation, the combination of stagnation and high prices that plagued the 1970s, is back in the developed world.

How can high prices coexist with a growth slowdown? Surely lower growth means excess capacity and lower pricing power? There are several reasons for higher inflation in the US. One of them is the startling rise in food prices, due to drought in many parts of the world and to diversion of farmland away to production of biofuels. Another is the steep rise in the price of crude oil.

These price rises are often laid at the door of India, China and the rest of the emerging world, the argument being that their development is pushing up the price of food and commodities. That’s a marked change from the earlier received wisdom, which argued that the absorption of huge quantities of labour power from China and India into the world economy had pushed down the costs of goods and provided a lid on prices. That, in turn, was supposed to provide central banks more leeway to cut interest rates without risking inflation.

Now, however, that benign effect is supposed to have run its course, with inflation in China at an 11-year high, forcing the Chinese central bank to raise interest rates for the sixth time this year. That’s forcing up the price of exports from China.

The other reason for higher US inflation is the weak dollar, which increases the price of imports in dollar terms. Over the past 12 months to November, the US price index for petroleum imports was up 53%, while overall import prices increased 11.4%, the largest annual advance since the index of import prices was first published in September 1982. The price of imports from China, the low-cost producer that accounts for 14.9% of US imports, was up 2.3% in November, compared with the same month last year.

Nor is it only in the US that inflation has been resurrected. In Europe, inflation in the 13 nations that use the euro was at a year-on-year rate of 3.1% in November, a six-year high. But could the high inflation rates be a backward-looking indicator? Once global growth starts slowing down seriously, won’t inflation die a natural death?

Much depends on the strength of China, India and other emerging markets. If they are able to “decouple" their economies from the US, then global growth may stay strong and the pressure on commodity prices could continue to be high. IMF has said China, India and Russia accounted for more than half of global growth last year.

The fear is that if growth stays strong in these economies, global commodity prices will stay high and that, coupled with a weaker dollar, will stoke inflation in the US, in spite of low growth there.

On the other hand, all predictions are that global growth will be lower in 2008 than in 2007. And if world growth is lower, shouldn’t prices too fall? Moreover, the consensus is that emerging markets too will be affected, to some extent, by the slowdown in the developed countries.

Both Morgan Stanley and Goldman Sachs Group Inc. have said that 2008 will be the year of “recoupling", as economies all over the world slow down together. And if that happens, commodity prices will trend lower. In fact, The Economist’s commodity price index for metals is down 13% this year and lower by 6.6% in the past month.

On the other hand, The Economist’s price index for food items is up a whopping 42% this year and higher by 10% in the past month. Could rising food prices be the Fed’s nemesis? Perhaps not.

While revising downward its forecasts for the 2007 crops, the UN’s Food and Agricultural Organisation says the latest indications point to a “significant increase in the world wheat area for 2008".

So while a second consecutive year of a reduced global wheat crop and low levels of stocks have led to wheat prices spiralling upward, that may change next year. In short, while inflation is a problem now, it may not remain so when growth slows further in the developed nations. That’s the conclusion reached by Morgan Stanley’s Joachim Fels, who writes: “Right now, most central banks in the advanced economies are still reluctant to ease, given still-strong growth and rising inflation pressures. Only the Fed, the Bank of England and the Bank of Canada have cut rates so far. But with weaker growth or even a mild recession ahead, I expect more central banks to reverse course and join these three in cutting official rates in 2008."

Of course, there isn’t even a whiff of stagflation in the developing countries. In India, growth is likely to be around 8% next year.

The concern is purely from the market’s point of view of inflows slowing down should the US Fed stop cutting rates, thanks to higher inflation. But while stagflation may be there in the developed world today, it’s likely to be gone tomorrow. And, for emerging markets, a growth scare in the US, which can be tackled by lowering interest rates and increasing liquidity, is a much better option than an inflation scare.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at