Inflation. It’s different this time.
It’s still got the same old causes: too much money pumped into the economy, huge economic stimulus that’s causing a shortage of goods and labor in some sectors, budget deficits and long-term debt that’s spiraling out of control and leading to the steady erosion of the value of money.
What’s different though is its source: The over-heated economies of the developing world.
And the speed of its advance: This inflation isn’t creeping higher; it’s galloping.
Here’s the big picture.
Inflation is tame in the world’s developed economies at the moment—largely because economic growth in these still damaged economies has been so slow.
But inflation may already be running out of control in the world’s developing economies—largely because they weren’t quite as damaged in the global financial crisis and have bounced back to rates of growth that were higher than those in the developed economies of Europe, Japan and the United States even before the crisis hit.
In the United States, for example, in February inflation at the consumer level (CPI, or Consumer Price Index) ran at an annual 2.1% rate. At the producer level, inflation ran at an annual 4.4%. But although a high rate of inflation at the producer price index is often a sign of consumer inflation to come—as higher wholesale prices lead to higher consumer prices—the PPI (Producer Price Index) actually fell in February.
In China, on the other hand, inflation at the consumer level ran at a 2.7% annual rate in February. That would be nothing to worry about except that the rate is up strongly over January and December, and China’s Producer Price Index climbed at a 5.4% annual rate in February. That was a big jump from the 4.3% annual rate in January. Which was in turn a huge jump from the 1.7% annual rate in December.
India, Brazil, Vietnam, and other developing countries are showing the same increase in the inflation rate. (For more on this see my posts “Inflation is breaking loose in China and India” http://jubakpicks.com/2010/03/19/inflation-is-about-to-break-loose-in-china-and-india/ and “Will April bring higher interest rates in Brazil?” http://jubakpicks.com/2010/03/23/will-april-bring-higher-interest-rates-in-brazil/ )
Inflation is kicking up so strongly in the world’s developing economies for five reasons
- First, since their economies weren’t as hard hit by the global financial crisis, they’ve bounced back hard after relatively modest—or in the case of China relatively and absolutely huge—stimulus efforts. (China’s stimulus—if you combine money from the government with an avalanche of bank loans—dwarfs that in the United States.)
- The governments of these countries don’t think they have much choice but to pursue pedal to the metal growth policies to stay even with the demand for jobs by young and fast growing populations.
- These countries were experiencing strong inflationary pressures in key sectors—food in India and China, raw materials in just about every economy but Brazil—before the global financial crisis and the global economic slowdown. The current rise in inflation is back to business as usual in these sectors. In many instances—raw materials such as iron ore or copper, for example– increasing global supply requires investing in new capacity that can take three to seven years to get into production.
- Most of these economies are built around export models so that higher growth means big surpluses of foreign exchange added to the money supply. Fast economic growth also makes these countries magnets for international capital, which again adds to the domestic money supply.
- Many of these economies are riddled with classic supply side bottlenecks. China, for example, has ambitious plans to expand its rail network but it doesn’t have the domestic capacity to produce all the rolling stock it needs. Imports could supply some of the demand while China’s rail equipment makers geared up production but the country’s export model works to discourage imports. So China’s rail and construction companies are left scrambling for the equipment and goods they need—driving up prices in the process. India’s persistent food inflation, to take another example, is made worse by an antiquated system of storage and transport that lets somewhere between 25% and 40% of some crops spoil before they reach market.
In recent history the U.S. experience with inflation has been with either the slow, dragged out, resistant to easy cures inflation of the 1960s through the double-digit rates of the early 1980s, or the inflation threat of a few quarters that’s been quickly snuffed out.
I think we’re looking at something quite different now in the inflation that the developing economies are exporting to the global economy. And in what comes after this wave of developing economy inflation.
I think we’re looking at something much more dramatic than typical U.S. or developed economy inflation. Growth in inflation in developing economies starts from a higher level because these economies emphasize growth over price stability (and who says they’re wrong to do so?) The European Central Bank wants to keep inflation under 2%. The target of Brazil’s central bank is 4.5%.
But more importantly we’re looking at a shift from a global economy where China and other developing country economies were exporting deflation in the form of a larger and larger supply of cheaper and cheaper goods to one where prices are rising on the shelves at Wal-Mart.
And once the cycle moves from rising inflation to a fight against inflation, the effect will be much more dramatic than the usual slowdown in the global economy that results from, say, the United States slowing growth to fight inflation. Because the developing economies of the world have in the last two decades or so become the world’s factories, they’ve become the marginal buyer in raw material after raw material. It’s Chinese, and Indian, and Indonesian, and Vietnamese demand that sets the price for copper and iron and nickel and, well, you name it. The rally in commodity prices that has helped pull global stock markets out of the dumps has been built on a foundation of an increase in demand from the developed world.
The financial markets are clearly afraid of what a drop in that demand would mean for commodity prices—and I think the financial market is right to be afraid. Policies designed to fight inflation that slow the economies of China, Brazil, Indian and the rest of the developed world will send commodity prices tumbling and that will, if stock market action so far in 2010 is any guide, be enough to stall, at least, the rally that began in March 2009.
The effects of slowing developing world economies will be more or less dire depending on whether developed world economies are ready to pick up the slack. On current data I don’t think Japan, the United Kingdom or the European Union about to shift into a higher economic gear. That leaves the United States and the real strength of the U.S. recovery is still very difficult to judge.
I think the most likely scenario is for inflation in the developing world to push still higher in the next few months as the governments of these countries fight internal battles over where to strike a balance between growth and inflation. That’s likely to produce the kind of over-heated growth that will keep commodity prices rising but also generate fear about the eventual crackdown to depress performance in developing world financial markets, especially China’s.
A likely consequence is that the U.S. stock market could for the next three months or so outperform the markets of the developing world. (For more on that theme see my post http://jubakpicks.com/2010/03/19/how-long-can-this-last-the-u-s-stock-market-is-out-performing-the-world/ )
Once the central banks of the developing world get serious about inflation, though, I don’t expect a prolonged battle like that the United States fought in the twenty years before Paul Volcker succeeded in breaking inflation in the 1980s. That’s because the inflation we’re seeing in these economies is a relatively recent phenomenon that hasn’t yet produced the kind of ingrained inflationary expectations that the United States saw in the 1970s and that Brazil suffered through in the 1970s and the first half of the 1980s.
I would expect that the battle against this round of inflation exported by the developing world will be painful, deeply painful, but brief—a matter of quarters rather than years.
The biggest pain will be felt by investors who stayed with commodities and commodity stocks too long—enticed by the gains from the over-heating of these developing economies. Those commodity positions will take the biggest beating in any whip inflation now slowdown in the developing world.
Watch out too for what I’d call Inflation II. There’s a good chance that while an inflationary spike in the developed world gets all the attention, inflation in the developed world will be gradually sneaking in the back door. Remember that the big additions to money supply came in the United States, Europe, and the United Kingdom.
China and Brazil may have a better chance of fighting and beating inflation because it will be so dramatic in those countries. The United States, Europe, and the United Kingdom might more closely resemble the frog in a pot of ever-so-gradually hotter water.
We won’t know inflation’s a danger until we’re cooked.