The Oil Shock Debate: Recession, Inflation or Both?
May 29, 2008
By Richard Berner | New York & Global Economics Team
Soaring oil prices are evoking unpleasant memories of the 1970s, when oil shocks triggered recessions, double-digit inflation, and a period of stagflation. Crude quotes have jumped by 30% (and by $30/bbl) since the beginning of the year, and they have doubled in the past year. Such a jump has almost always led to a significant downshift in economic growth. On the surface, we think the outcome this time will be similar, depressing global growth, especially in the oil-consuming economies, and pushing up inflation to the highest level since the Gulf War.
But a global recession and significantly higher inflation are tail events and not part of our baseline view. The stagflation debate is less settled; stagflation is a risk but a relatively small one. There’s no question that in many cases, easy money is contributing to higher global inflation. But this time accommodation is mainly in the developing, rather than in the developed world. In any case, investors should consider insurance against growth shortfalls, higher inflation and multiple compression. Excerpts from a debate among members of our global economics team last week will help explain why. First, why are energy prices soaring and how high can they go? In our view, oil prices are soaring because supply constraints are biting against the backdrop of still-strong global demand. The supply limitations are both perceived and real; there is no proven ‘shortage’ of crude or product, but spot outages and tight markets have created fears of one. For example, crude outages, particularly in Nigeria and the North Sea, have recently contributed to such fears. Eric Chaney notes that supply has repeatedly failed to grow faster than demand, leaving the spare capacity too low to cope with permanent risks of supply disruption due to geopolitical risks. Effective OPEC spare capacity stands at just over 2 mb/d on paper, although refinery outages, low OPEC crude quality, and high prices mean much of their oil would be difficult to market under current conditions. Indeed, the International Energy Agency (IEA) is conducting a study of the capacity of the world’s 400 biggest oil fields in countries like Venezuela, Mexico, Saudi Arabia, Kuwait and Iraq. The conclusions are out: Future supply will be tighter than previously estimated, and required investment to produce the crude will be much bigger than previously thought. Such estimates have increased the risk premium attached to future oil supply and prices. This news, together with growing inventories, recently shifted the oil market from backwardation (spot prices above futures) to contango (futures prices above spot). The first few months of the curve have returned to backwardation, which commodity strategist Hussein Allidina believes reflects the realization that refiners are coming out of spring maintenance and in the coming weeks and months will run hard to produce distillates; that should promote a strengthening in near-dated time spreads. But the contango further out the curve reflects the growing recognition that supply limitations will persist. As for demand, higher prices are causing “demand destruction,” but only in regions where consumers see price signals. OECD demand for crude oil is likely to decline for the third year in a row, although perhaps by less than the 1.0 mb/d drop which the IEA is currently estimating. Demand is strongest in the booming emerging economies where subsidies artificially depress prices. Non-OECD demand growth in 2008, led by China and the Middle East, remains strong at 3.7% or 1.4 mb/d, leaving growth for the world as a whole at 1.2% (+1.0 mb/d). So, while prices are high enough to curb demand in the developed economies, we think that supply limits and overall demand growth could easily take Brent crude quotes to $150/bbl. This will represent a supply shock for the global economy – and a big one indeed. Our China economist Qing Wang has a different perspective. He notes that high oil prices reflect supply constraints but are not the result of a supply shock, because there is no surprise cutback. Strong demand that outpaces supply is the dominant factor and is a sign of strength instead of weakness of the economy. In this context, given the supply constraints, one possible scenario is that fast-growing EM countries (e.g., China, India) may “crowd out” slow-growing EM countries and OECD countries. Financial markets in slow-growing EM economies may be more vulnerable than those in OECD countries because investors expect rapid EM growth. So will this shock trigger a global recession? Hussein Allidina observes that the impact on the global economy and ultimately oil price differs depending on the source of the shock. We agree. Oil prices rose steadily from 2002 through 2006 on the back of strong global demand. In contrast, we think this supply-induced surge in oil prices will depress global growth. Nonetheless, our team believes that a global recession is unlikely for three reasons. First, the price hikes transfer income from consumers to producers, and the oil producers are spending much of the oil revenue. Second, subsidies mute the price hike’s impact in many consuming countries. And third, central banks don’t seem inclined to tighten monetary policy to offset the potential inflationary effects of the price hike, at least so far. Nonetheless, the shock likely will hurt oil consumers much faster than producers can “recycle” the income transfer. And it comes on the heels of the financial and housing shocks in the US and other industrial economies. Moreover, some EM economies, like Indonesia, are raising previously-controlled fuel prices, which will depress income and growth there. As a result, it will magnify downside risks to growth. But this debate is far from settled. Joachim Fels is not sure how big a risk higher oil prices creates for global growth, because they simply redistribute money from oil importers to exporters. Do exporters have much higher savings rates, or do they happily spend the extra revenues on capital goods, football clubs, yachts, etc.? And even if they have higher savings rates, doesn't that add stimulus through financial recycling, promoting lower interest rates and higher equity prices than otherwise? Recycling one way or the other should cushion the blow somewhat for oil importers. But Eric Chaney points out that this longer-run analysis may overlook the divergences in the dynamics of the various shocks. In particular, the supply-side shock of higher prices for the oil consumers is immediate, while the recycling of oil income likely has longer lags. Also, it seems clear that (large) oil producers have a higher saving propensity than oil importers, or else their reserve accumulation and the growth of Sovereign Wealth Funds among the oil producers would be far smaller. Supply has systematically surprised on the downside everywhere in the world. Price signals should normally increase supply, both of crude and products, but they haven't or at least the impact is surprisingly muted. With the benefit of hindsight, there are many reasons for that: It's harder and more expensive to find 'new oil'; nationalized oil companies have poor incentives to raise long-term return; many governments (Russia, Venezuela, Nigeria) see oil as a welcome rent and keep raising taxes and thus reducing incentives to invest; political chaos in the Middle East makes investment highly risky. Last, it matters whether a country is a net oil exporter or importer. The UK is more impervious to oil shocks because it is not a significant net oil importer. In the UK, the oil price shock still involves a transfer of income — but from end users to BP and the government. The upshot from all these cross currents: A higher risk premium on oil prices. This is not a 'pure supply-side shock' like those in 1973 and 1979, when supply was suddenly cut by a significant amount, causing disruptions in the global economy independently from the price shock itself. Then, the rationing of oil hobbled growth. Today, we have more of a notional supply shock, manifest in prices. Still, David Miles believes that the right way to think about oil price rises is that they are a nasty terms-of-trade shock to oil importers (and a terms-of-trade improvement for exporters). Both the losers and the gainers smooth their spending: The losers may borrow a bit more initially (run bigger current account deficits), and the gainers don't spend it all immediately but save a proportion — probably via SWFs which recycle savings back to the losers, allowing a smoother downward trajectory of the latter’s non-oil spending rather than a sudden plunge. Spending power is not lost — just redistributed. Gerard Minack disagrees. He thinks that such recycling back to consumers seems less likely now, for two reasons. First, with growth in oil producers already very strong, it seems that the latest additional windfall almost cannot be spent. That suggests that much more of the additional revenues now accruing to producers will be saved, not recycled into higher import demand or domestic activity. Second, the surplus saving from oil producers was arguably an important source of liquidity through the credit boom. That boom supported spending in oil-consumer nations. But with the credit system in disarray -- and borrower rates now significantly higher than a year ago -- it seems unlikely that recycled liquidity will be as effective in maintaining demand in oil consumers. In fact, all the available evidence -- from buying football teams to SWF investments to the widening in credit spreads -- says that those flows have fallen, not increased. To the extent flows from oil producers continue, they -- like other sources of capital -- have clearly become more risk averse. Dick Berner points out another negative for the oil importers: the collateral loss of wealth associated with the increase in energy prices. The change in relative (energy) prices that is both permanent and beyond expectations makes a portion of the capital stock in the oil-consuming countries obsolete. That will be reflected in claims on that capital (equity prices), in future taxes (to build new infrastructure), and in housing and consumer durables. US airlines are a prime example. And houses an hour's commute from LA that looked attractive when gasoline cost $1.50/gallon, and that now are caught in the subprime meltdown, will be worth even less with $4 gasoline. This loss in wealth is potentially permanent. Of course, capital obsolescence creates a need for new, more energy-efficient capital and will eventually trigger more investment. But by reducing wealth, it will first depress demand in the oil-consuming economies — especially those least energy efficient. Qing Wang notes that this wealth effect probably becomes particularly important for EM countries like China when it reaches a threshold: When oil prices are higher than a certain level, lots of energy-intensive capital stock or industrial practices will be rendered obsolete. This nonlinear impact of high oil prices should be more damaging for China than industrialized countries, although China is perhaps better positioned to cope with this shock given its strong financial cushion in the short run. How high will inflation go? And how long will it stay elevated? The surge in oil prices should boost already-elevated global inflation to nearly a two-decade high. US headline inflation likely will rise to 5% to 5½% this summer, European inflation will probably exceed 3½%, and inflation will reach double-digits in a growing number of emerging economies, especially those whose currencies are pegged to the dollar and who are oil producers. The hike will boost inflation uncertainty globally. How long headline inflation stays elevated will depend on the direction of oil quotes and the pass-through into other prices of higher energy costs — and on the willingness of monetary policy to rein it in. Supply-induced energy price spikes always create a dilemma for central banks in oil-consuming countries, faced with higher inflation and slower growth. Although the recent rise in headline inflation and in surveyed inflation expectations makes the Fed nervous, if they view this rise in inflation as the transitory result of a supply shock, they will not tighten, at least not soon. For the producing countries, especially the “dollar peggers,” the issues are whether they have the resolve to tighten policy and change their exchange rate regime. We suspect neither, with the result being upside risks to inflation. Eric Chaney is amazed at the current complacency about inflation and the economic pain it will take to bring it down again. In his view, if central banks want to bring back inflation to 2% or so, they will have to widen domestic output gaps (i.e., tolerate a recession) in order to curb core inflation and offset the rise of non-core. At least over time, inflation-targeting central banks have no other choice. But not all banks target inflation. The central bank response will likely be distributed along an axis from complacent to 'leaning against the wind,' and the global outcome will depend on the weighted distribution of these policy stances. Joachim Fels thinks it is more likely that central banks either suspend their inflation targets, revise them higher, or allow themselves more time to get inflation back to target. The ECB is a case in point: The experience of the first ten years of EMU suggests that the ECB's definition of price stability -- an inflation rate of less than 2% -- is too ambitious. The definition dates back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, weighed down on inflation. That was then. Today, emerging market economies -- through their very expansionary monetary policy stance and their hunger for food and energy -- have become a source of global inflation. In most countries he sees monetary policy as expansionary, so central banks are accommodating or even fueling the oil and food price rally. If there is no monetary tightening, it is hard to see why a recession should ensue. In contrast, Elga Bartsch and Dick Berner think most central banks will opt to take more time to get back to target. But they won’t move the goalposts: The last thing they want to risk in this environment is to un-anchor inflation expectations by ratcheting up the target. More than ever this is about avoiding “second round” effects. She and Dick agree that few central banks would react to a supply shock by hiking rates; they would accommodate such a shock. But because it is not entirely clear that we are seeing only a supply phenomenon — strong demand also is involved — central banks need to react. Moreover, Elga thinks the recent US monetary expansion will eventually put Bretton Woods II (the tacit arrangement pegging other currencies to the dollar) to the test; the end game might or might not be the same as in the 1970s with Bretton Woods I. If so, this would reinforce the inflationary pressures in the US. In order not to appear complacent — as Eric correctly points out —central banks could get serious about price level targets and commit to make up for the present overshoot in the future. Gray Newman notes that if EM central banks maintain their accommodative policy path — at least in Latin America, where central bank credibility is still in its first stages of development and where financial intermediation hardly exists (making one of the channels of monetary transmission less effective) — it's a recipe for a hard landing. Michael Kafe says that at least one EM central bank — the South African Reserve Bank — isn’t wavering. For this strict inflation targeter, preventing second-round inflation is important, harnessing inflation expectations is crucial, changing the target range/band is not up for consideration, and they appear willing to tolerate a high sacrifice ratio in the pursuit of price stability. In contrast, Qing Wang sees a failure of global anti-inflation policy coordination at the current juncture. In the face of global supply shocks, central banks appear to be playing the game of "who blinks first" by refraining from raising rates and resorting to unorthodox measures (e.g., fiscal subsidies and price controls) to manage inflation pressures, hoping other countries blink first and take tightening measures which help slow activity and demand for commodities. China is also playing this game, but may actually be among the last to blink, in view of its strong macro balance sheet (e.g., low government debt and sizable FX reserves). What should investors do? Global yields seem likely to rise with rising energy prices, and that may pressure yields in the US; transatlantic spreads are already down to -40 bp again. Nonetheless, it is remarkable that although we have seen inflation rise a lot in developed economies – and with more in the pipeline – nominal 10-year yields are under 5% across Europe and under 4% in the US. These developments support Gerard Minack’s hunch that developed-economy bond markets see rising oil prices as a growth-negative rather than an inflation-positive. With supply constraints the new factor pushing prices higher, the impact on developed-economy growth is likely to be more significant than when price strength reflected demand outstripping supply expansion. What central banks do in response will dictate the shape of the yield curve, and we expect them to lag, resulting in steeper curves. For risky assets, the strategy is more transparent: Higher inflation will also undermine equity multiples and currencies in the countries where monetary policy lags behind. And to the extent that the energy shock is a negative for growth, earnings will suffer. Equity markets are waking up to that reality.
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Inflation – Think Global, Act Local
May 29, 2008
By Marcelo Carvalho | Sao Paulo
We are revising up our inflation and interest rate forecasts. We are moving up our IPCA inflation forecast for 2008 to 5.8% (from 4.4%), and for 2009 to 4.8% (from 4.5%). What’s new? Upward pressures from food and wholesale price inflation are proving stronger than anticipated. Not only that, but this takes place against a global inflation backdrop which has deteriorated significantly in the last month or so, as international oil prices break yet new highs. We expect the central bank to respond with stronger monetary tightening than previously foreseen. We now think the total tightening cycle will be 300bp (200bp before), peaking at 14.25% by December 2008, with an accelerated 75bp (50bp before) move at the upcoming June 4 meeting. The Selic rate should eventually decline late next year, to 13.25% by end-2009. Monetary tightening should slow domestic demand into 2009. Prospects for tighter monetary conditions reinforce our view that growth will end 2008 softer than it started the year. We reiterate our real GDP growth forecast of 4.3% in 2008 and 3.0% in 2009. Food for Thought Brazil is suffering from a serious case of food (price inflation) poisoning. IPCA inflation increased to 5.0%Y in April, from 4.5% last December. Food price inflation has been a key driver. It increased to 10.8%Y at the end of 2007. We had assumed a deceleration in food price inflation in 2008, to about half of its 2007 pace. That assumption no longer appears plausible. Food price inflation actually accelerated to 12.6% in April, and we estimate it would hit 14% in May. In the first four months of the year alone, monthly food price inflation has already accumulated 4.3%, and May looks bound to bring a monthly reading in the 1-2% range. Food contamination? Signs of direct spillover seem relatively limited so far, from food price inflation into other consumer basket items. Non-food price inflation stood fairly stable at 3.0% as of April. However, there is a divergence within non-food price items. Price inflation for administered (or monitored) prices has declined to 1.6% as of April. By contrast, market-driven non-food prices have climbed 4.0%. These prices have risen somewhat for non-tradable items (such as services), but have increased more clearly for tradable goods, from a very low starting point a year earlier. As for administered prices, these will likely bottom out soon, and look set to rise to the 3-4% range by the end of the year, and probably higher in 2009, in part reflecting rising general price (IGP-M) inflation. What is the role of the currency? Tradable price inflation (ex food) conceptually should be the item more likely to reflect currency swings. Indeed, the currency matters for tradable price inflation, with a time lag of about six months. Unsurprisingly, large currency swings were a key driver for inflation back in 2002-03. But it seems that the importance of the exchange rate for inflation could be fading over time. That would be consistent with evidence from the international literature, which finds that currency pass-through coefficients tend to fade over time, as economies mature and the currency becomes less of an anchor for inflation expectations. What about the output gap? Inflation for market-driven, non-food items has risen lately, possibly reflecting rising industrial capacity utilization, although the correlation is not always tight. What is driving Brazil’s food price inflation? There is little doubt that Brazil’s rising food inflation has a lot to do with global forces, as international prices for food-related commodities go up, even though currency appreciation has helped to cushion the blow somewhat in local currency terms. More broadly, there is empirical international evidence suggesting that global factors have become a more important driver of inflation than domestic factors nowadays in several countries. Wholesale price inflation is on the rise too, and will keep the central bank concerned about pass-through into CPI inflation from pipeline pressures. Agricultural WPI is typically more volatile, and has already jumped close to the 30%Y mark, from negative terrain a couple of years ago. Perhaps equally relevant for the central bank, however, is the recent rise in industrial WPI, mainly reflecting rising global commodity prices (such as for iron ore), besides oil-related pressures, such as on fertilizers and diesel oil. Our estimates suggest that pass-through from WPI into CPI can be fast, within one to three months. Agricultural WPI feeds into IPCA food prices, while industrial WPI shows most visibly in IPCA inflation for tradable goods, ex food. The pass-through coefficient appears stronger for agricultural goods than for industrial items. Think Global, Act Local Brazil’s food price inflation is comparable to global trends. Food price inflation varies across countries, as does the share of food in household budgets around the world. Brazil seems to be somewhere in the middle of the pack. Food price inflation in Brazil is higher than for many other countries, but its share in the CPI index is not far from the international average. Inflation in Brazil is currently closer to target than in many other countries. In the vast majority of inflation-targeting countries, headline inflation is running above target, and in most cases it is actually above the ceiling of the inflation band too. Brazil’s inflation target is 4.5%, with a tolerance band of two percentage points either way. However, Brazil’s inflation target is not particularly ambitious by international standards. And its tolerance band is relatively large. The resulting 6.5% target ceiling therefore looks high by international standards. How would Brazil’s central bank respond to rising (global) inflation pressures? The COPOM has already voted with its feet, so to speak, when it started hiking rates on April 16. The central bank seeks to avoid contamination from food into non-food price inflation. It seems particularly concerned that food prices are highly visible, and thus can potentially contaminate inflation expectations and wage negotiations. Also, the central bank aims to reduce the mismatch between domestic demand and supply, which it fears can add fuel to inflationary pressures. The central bank worries that inflation goes beyond just food in an environment of strong domestic demand. A 50 or 75bp hike on June 4? The central bank started hiking rates with a surprisingly large 50bp rate move, in April. Ironically, 50bp now seem a floor for the upcoming policy decision. We are changing our forecast, from 50bp to 75bp for the June meeting. It is a close call. One main argument for keeping a 50bp pace is that the central bank might have already foreseen recent inflation deterioration. By contrast, a key argument in favor of a 75bp hike is that the authorities have expressed their preference for front-loaded action, arguing that aggressive early action can help reduce the size of the full hiking cycle. New forecast: a full cycle of 300bp. Our revised forecast sees a 75bp hike in June, another 75bp in July, and then 50bp in September and another 50bp in October. The policy rate would peak at 14.25% by end-2008, with eventual monetary easing late next year pulling it down to 13.25% by end-2009. The consensus view in the latest central bank survey among analysts sees policy rates at 13.50% at end-2008, and 12.25% at end-2009. Risks to our revised inflation and rate forecast could still prove biased to the upside, if global inflation pressures end up more challenging than currently assumed. That would entail higher IPCA inflation and more monetary action in Brazil. Of course, there is downside risk too. An outright decline in global food prices could go a long way in alleviating headline inflation pressures in Brazil, and could facilitate COPOM’s job. Expect increasing local talk about adjusted inflation targets and tolerance ranges. As monetary policy tightens, and possibly by more than the central bank planned at first, suggestions for alternative policy action may mushroom. Some will suggest that the central bank should actively and explicitly use the two-percent tolerance band around the 4.5% target center. Others will propose that the 4.5% target for next year should be adjusted (upward) in order to accommodate the external price shocks. The central bank seems to resist such proposals. The national monetary council is scheduled to announce on June 26 the official inflation target for 2010. That should prove a lively debate. Growth Implications In turn, monetary tightening should eventually slow down the economy, with a time lag. After all, the very purpose of the ongoing tightening cycle is to cool down domestic demand, which the central bank believes is currently growing above potential. Average real GDP growth in 2008 will still remain robust. Real 1Q08 GDP data are scheduled to come out on June 10. It should be a strong reading, although possibly a bit shy of the 6.2% pace seen in 4Q07. Year-on-year growth in 1Q08 was probably in the 5.5-6.0% range: we forecast 5.8%. Firm labor markets and ongoing credit expansion should support the economy through 1H08. In all, strong statistical carryover from 2007 into 2008, besides growth momentum, ensures that the average real GDP reading for 2008 as a whole should remain robust, almost certainly above the 4.0% mark. Our 2008 forecast sees 4.3%. The latest consensus view calls for 4.7%. But the annual average can mask sequential growth deceleration through the year. 2008 will end weaker than it started, if our forecast proves right. Monetary tightening could temper credit conditions, should cool down consumer and business confidence over time and could thus eventually chill consumption, investment and hiring decisions. Also, rising food price inflation may erode consumer disposable incomes, particularly at the low end of the income spectrum. In all, we assume that year-on-year growth comparisons slow from the 5-6% range in 1H08 to the 3-4% range in 2H08. Growth will start 2009 on a softer note. Growth deceleration later in 2008 will mean that statistical carryover and growth momentum into 2009 may show opposite dynamics from 2008. Given time lags, the full cumulative impact from expected monetary tightening will be fully felt only in 2009. Prospects for tighter monetary conditions reinforce our confidence on sub-par growth next year. The latest market consensus sees average real GDP growth at 4.0% in 2009. We reiterate our forecast for 3.0%. Growth risks: upside for 2008, downside for 2009? One upside risk is that global growth figures prove more resilient in 2008 than expected. Still, import volume growth looks set to remain above export volume growth, and thus the contribution from net exports to Brazil’s overall real GDP growth is set to remain negative. Rather than net exports, domestic growth dynamics have driven Brazil’s overall GDP trends lately. Here, one upside risk is that positive domestic demand momentum lingers for longer than our 2008 forecast assumes. But that could well actually entail stronger policy tightening, and thus more pronounced growth slowdown in 2009. As for global conditions, risks for 2009 would arguably appear skewed to the downside, if global growth takes longer to recover than currently envisioned. Bottom Line Rising food and wholesale price inflation, amid worsening global inflation conditions, worsen Brazil’s inflation outlook. The central bank will respond with decisive action. We are revising our 2008 IPCA inflation forecast to 5.8% (from 4.4%), and the full hiking cycle to 300bp (from 200bp before). Prospects for tighter monetary policy increase our confidence that real GDP growth in 2009 should prove sub-par.
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AXJ’s Inflation Challenge
May 29, 2008
By Chetan Ahya | Singapore, Qing Wang | Hong Kong & Asia Pacific Economics Team
Over the last few months, we have been concerned about the cyclical rise in core inflation in the AXJ region (see End of Disinflation Cycle? October 26, 2007). Those concerns now seem to be emerging as a reality. Headline inflation is at a nine-and-a-half-year high of 7.5% in April 2008. Core inflation (ex-oil and food) is at 3.8%. This compares with the GDP-weighted average policy rate of 6.75% and 91-day T-bill yield of 4.95%. The last time AXJ inflation was this high was only for a short period following the Asian crisis, due to the large depreciation in exchange rates of many countries in the region. The AXJ region, which has been a key contributor to global disinflation over the last few years, is itself now witnessing a rise in headline inflation at a time when the developed world has also seen an uptick in inflation. In the following discussion, we present our thoughts on the topic of inflation in three parts: (1) what explains the rise in AXJ inflation?; (2) understanding the global backdrop; and (3) what is the likely policy response to a rise in inflation in the region? Part I: AXJ Inflation Close to a 9.5-year High Core inflation is on the rise all across the region. Making a case for a structural rise in core inflation in Asia in a globalized world is difficult. The region still has a large proportion of the unemployed workforce, and more importantly, will still account for 40% of the increase in global working population up to 2017. Demographic trends are still likely to be supportive for India (until 2050) and China (until 2015). Having said that, we believe that the cyclical rise in core inflation is for real. Almost all economies in the region have seen a rise in non-food non-oil inflation, i.e., core inflation. We believe that the cyclical rise in core inflation is arising from the following developments: GDP growth is running above trend for longer: AXJ GDP growth has been consistently higher than the trend line for the past five years, implying that capacity utilization could be at cyclical highs. Continued strong growth may add to core inflation concerns. Persistent rise in global food, energy and other commodity prices: While the rise in commodity prices was initially absorbed, as the capacity utilization was low, increasingly this may become challenging if above-trend GDP growth persists. More important, the recent spike in food prices across the region may have implications for inflation expectations, considering that food forms such a large portion of the inflation basket in the region. While it may be debatable how much of the rise in these commodity prices is structural and how much is cyclical, the fact is that we are now entering the fourth year of rising commodity prices. Second-round effects are now beginning to come through in non-food non-oil inflation, thereby increasing the challenge of managing inflation expectations. Cyclical shortage of skilled workers in pockets: There are clear signs of a shortage of skilled workers in certain pockets, from senior managers to construction workers in the region. While until recently there was no serious evidence of unit labor costs rising, as productivity growth appears to be offsetting wage growth, it appears that the at-the-margin unit labor costs may be rising in at least some regional countries. In the absence of accurate data on productivity growth, we used the ratio of wage costs to total costs for the top 200 companies in India to assess the impact of rising wage costs on corporate margins. This ratio of aggregate wage costs to total cost has started to rise over the last three quarters. Trade unions in some of the smaller countries like the Philippines and Thailand are also beginning to make noise and demand higher wages. Tightness in non-tradeables market: Housing, education and health-related infrastructure shortages have pushed up the underlying inflation for non-tradeables. We are clearly observing this trend in India, Indonesia, Korea, and Singapore with the non-tradeables component of CPI witnessing higher inflation than the tradeables components (ex-food). In China as well, the non-tradeables inflation has risen, albeit marginally. Moreover, for some of the emerging economies like India, in which the share of services in overall consumption baskets is increasing rapidly, there is a good chance that official CPI indices are underestimating the underlying inflation in non-tradeables. With domestic demand growth remaining relatively strong across the region, the pressure of inflation in the non-tradeables segment is unlikely to decline soon. Indeed, even external demand has remained strong, as reflected in the export growth trend. Weakening exchange rate to add to inflation pressure: The steady weakening of the US dollar and appreciation of the USD/AXJ helped offset inflation pressure from tradeables to some extent; the recent reversal in USD/AXJ will add to the complexity of managing inflation and global commodity-linked and imported products. With a large part of the inflationary pressure arising from global sources, any further weakening of the exchange rate would only add to the inflation pressure. Part II: Putting Global Inflation Issues in Context Let’s ignore the message from the commodity markets. The message from oil and commodity markets is that current global aggregate demand is running higher than supply. During the five-year period ending 2007, global GDP growth averaged at 4.6%. This strong global GDP has been at the heart of this state of the commodity markets. In this context, the key question is, can global growth continue at the current pace without further capacity (resource) constraints? Who is going to contribute in the form of slower domestic demand growth to bring down commodity prices: the developed world or emerging economies or both? An even more difficult question is: what magnitude of global growth moderation is needed to ensure that the inflation challenge is managed effectively? However, one thing that seems clear to us is that a meaningful reduction in commodity prices without slower aggregate global demand is unlikely. Some of the factors that explain the global inflation spike are: No major slack in Asia: We do not have the significant excess capacity in Asia as a starting point that we had a few years back. Asia and several emerging economies suffered from a huge demand shock due to the Asian crisis and other emerging markets’ credit defaults. Many of these emerging economies have exhausted the slack in physical capacities and suffered from skilled labor shortages. No major global productivity boost recently: From the mid-1990s to the early 2000s, we had a big productivity boost in the US and the rest of the world due to the technology-related boom. China factor is no longer as disinflationary: China is not at the stage where it reduces the prices of global finished goods any more. Many other EMs are also witnessing a tight market for skilled labor. Even if we acknowledge that this is a cyclical problem as the demographics of many of these emerging markets will be favourable in the medium term, it does not take away the challenge for the next 12-24 months. Prolonged period of low real rates in the US: The US policy rates were low for an unusually long period between the second half of 2001 to 2004. Real policy rates have again moved into negative territory. Easy approach by EM policymakers: Most EM central banks are choosing to look at inflation ex-food and energy. Policymakers are taking comfort from the fact that, until recently, inflation expectations have been well-anchored. However, the longer headline inflation stays higher, the more entrenched the problem will be. Fed and Large EM Central Banks Will Decide Outcome The GDP-weighted global official policy rate is currently at 4.3% compared to inflation of over 5% (see Joachim Fels and Manoj Pradhan’s Stagflation – More Than a Scare, May 21, 2008). Our global economics team estimates that this global policy rate will rise by only 20bp further to 4.5% by September 2009. With the growth environment likely to remain subdued, our US economics team expects the policy rate to be hiked only in 2Q09 and rising up to only 4.0% by end-2009. Fed futures are expecting the first 25bp hike as early as January 2009. By their policy actions, many of the large EM central banks do not appear to be addressing the inflation challenge head on. Both the developed world as well as EMs need to slow aggregate demand to reduce inflation risks, in our view. While the developed world has witnessed some slowdown already, the rest of the world continues to grow at relatively high rates. For instance, in Asia not only has the domestic demand growth continued to be at high levels, but the external demand slowdown has also been cushioned by exports to the rest of the world (ROW, markets other than US, Europe and Asia), which has grown at a rapid pace. For example, in March 2008, AXJ’s exports to the US (which account for about 14% of the total AXJ exports) remained weak at 8.3%Y, while its exports to ROW (accounting for 22% of total AXJ exports) rose to an all-time high of 38.2%Y. Many EMs are also subsidizing commodities, tempering price signals to the consumer. For instance, in the three most populous countries in the AXJ region, domestic oil prices have been marked to significantly lower levels than the current global market price. In China, domestic refined products prices are marked to US$75-80/bbl; in India they are marked to US$65/bbl; and in Indonesia (even after the recent 28.7% hike) they are marked to US$85/bbl. While the adverse impact of higher inflation hurts the whole world, the EM economies will suffer more with a higher proportion of low-income population. However, to the extent that policy response from EMs has not yet been aggressive enough, there does not appear to be a quick solution to this commodity price rise and global inflation problem. Even if commodity prices are maintained at current levels, the higher pass-through into finished goods increases the risk of making the inflation problem more vicious. Part III: The Likely Policy Response If oil prices rise to US$150/bbl and stay there for more than 4-5 months, which countries in the region will likely respond in the form of a monetary policy action next? If crude oil prices rise to US$150/bbl and remain there for four months or more, we believe that there is a high probability that many counties in the region will see double-digit inflation. To assess the policy response from the policymakers under such circumstances, we tried to assess the potential pressure for policy action in the region based on the following factors: (a) current level of inflation ex-food and oil and trend in the last six months; (b) fiscal room to absorb oil subsidy; (c) real rate trend based on prime lending rates and 91-day T-bill rates; (d) domestic demand growth trend and level; (e) exchange rate strength; and (f) political tolerance on inflation and typical policy bias on growth versus inflation control. Based on the above factors, if oil prices rise to US$150 and stay there for four months and more, we believe the countries that could see a policy rate hike are Indonesia, Thailand, Taiwan and India. Indeed, the yield curve is already steepening in these countries. In Indonesia, we expect the central bank to be concerned about accelerating core inflation. We believe that the central bank needs to tighten to slow domestic demand, which is currently growing at 7%, supported by 30% growth in credit. We expect the central bank to tighten policy rates by 75-100bp to 9.25% and increase the cash reserve ratio by 50-100bp over the next 4-6 months, compared to our current base case of 50bp hike in policy rates and/or 50-100bp hike in the cash reserve ratio. In Thailand, elevated commodity prices, coupled with domestic demand recovery, will likely raise the possibility of second-round pass-through. If oil prices rise to US$150/bbl and stay there for 4-5 months, we expect the central bank to raise policy rates by 100bp over the next six months compared with our current base case of 50bp hike. We believe that, over the next 6-12 months, domestic demand will remain healthy, as real rates should be accommodative even after the rate hike. Similarly, in Taiwan, our economist Sharon Lam believes that improved political confidence and continued healthy external sector performance will mean that GDP growth will be stronger than consensus estimates at 4.8% in 2008. Growth is recovering and core inflation is rising. With the government having decided to remove the cap on domestic fuel prices, input cost pressures are likely to rise. In such circumstances, Sharon expects that the central bank in Taiwan could also hike policy rates by 50bp to 4% before the end of the year, as compared to her base case of a 50bp hike over the next four quarters. India has already tightened aggressively and domestic demand is slowing sharply, reducing the risk of a second-round effect of higher commodity prices. However, if oil prices continue to rise to US$150/bbl and capital inflows remain weak, we believe that the central bank will have to tighten further by increasing policy rates by 25-50bp (from the current 7.75%) over the next 4-6 months to ensure exchange rate stability. We believe that tightening may be required to protect the downside risk from inflation of further depreciation in the exchange rate, even if it comes at the cost of further compression in domestic demand. Korea’s weak current-account position and potential further slowdown in capital inflows could make it difficult to use exchange rate policy to offset pressure from rising global commodity prices. In the case of such a risk scenario, our Korea economist Sharon Lam believes that the central bank will choose to keep the policy rates constant as compared with our current expectation of policy rate cuts in 2H08. In such a scenario, downside risks to growth will increase. In China, our economist Qing Wang believes that the government will continue to rely on open-market operations and hikes in the required reserves ratio to mop up liquidity and keep money-supply growth in check. Moreover, the existing quantitative credit controls will likely persist, as policymakers are attempting to strike a delicate balance between their inflation and growth objectives. However, we think that the probability of rate hikes remains low, as the authorities will want to avoid attracting more FX inflows. If oil prices were to remain at US$150/bbl, Qing expects over 15% RMB appreciation versus the US dollar in 2008. In Singapore, our base case is for the central bank to maintain the status quo in the October 2008 policy review. If oil prices reach US$150/bbl and remain there, we believe that the policy response is likely to shift to the fiscal front, given that the MAS has already tightened monetary policy in the last two policy reviews. Indeed, to the extent that high commodity prices are more a reflection of strong demand in emerging economies and/or supply-side factors rather than domestic demand in Singapore, we believe that there is a limit to how much currency appreciation can be used to contain tradeables inflation without adversely affecting growth. If we are wrong on the monetary policy call and the MAS opts to tighten further, we believe that a widening of bandwidth and/or a resetting of midpoint are the more likely options. Oil prices at US$150/bbl would also likely put a floor under further declines in the SIBOR.
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