Signs of a global economic recovery are creating concern about prices. While there is no imminent threat, the outlook is not as rosy over the longer term.
It is never too early to plan for inflation
The recent data on global inflation fuel the debate on whether prices are trending up faster than they should. In the west, where deflation has ruled over the past year, recent data surprised on the upside in the UK but on the downside in the US.
In the east, India, which has struggled with structurally high inflation for most of the past decade, continues to battle vigorously by raising interest rates for the second time this year to contain double-digit headline inflation. While mild inflation is desirable in a debt-laden global economy, if nothing else than to skew the risk away from deflation, excessive inflation is undesirable since it erodes purchasing power and is akin to taxation without legislation, as the adage goes.
If the global economy continues to recover in the months ahead, as we expect it to, the debate about inflation's tax on growth will gain intensity. Adding fuel to the possibility is a rise in the price of oil, which at US$80 a barrel pushes the boundary of consumer comfort. On a global scale, inflation will likely be a secular, not a cyclical phenomenon, which means it is not imminent given substantial excess capacity and economic deleveraging in advanced economies, but in the long term it is inevitable given the substantial government deficit spending and excess money supply.
Also, to the degree we are tripped by inflation, it is more likely to be a regional phenomenon. In certain parts of the populous and fast-growing emerging world, it is likely to challenge policymakers. Meanwhile, all appears rosy with low interest rates having rapidly reflated asset prices in the past year in most regions and asset classes. As economists jest, present prosperity with high blood pressure will eventually induce inflation.
Most analysts forecast a varied recovery for the global economy, with low growth in the developed world and high growth in the emerging one. Similarly, inflation is likely to be low in the developed economies and high in the emerging ones. Overall, we can also expect that headline inflation will substantially exceed core inflation, especially due to expensive energy and food, which are sectors where there is least gap between excess capacity and rising demand.
Also, in these headline sectors there is more potential for disruptions due to weather, as in the case of a poor monsoon in India last year, or geopolitical crises. The current average of global inflation forecasts is 3.2 per cent for this year, with Europe likely to be the lowest at 1.2 per cent, the US at 2.3 per cent, emerging Asia and Latin America at about 4.5 per cent and emerging Europe, Middle East and Africa at 6 per cent.
But there is substantial disagreement among forecasters. For example, the range of US inflation forecasts varies between 0.5 and 5.2 per cent for next year with an average of 2.1 per cent, while the forecast for China varies from 2.5 per cent to 4.6 per cent with an average of 3.6 per cent. In Asia, India stands out having recently reported inflation of 9.9 per cent, well above the government's comfort level of between 5 and 6 per cent. Worse, the food component of inflation is now in the range of 15 to 20 per cent, which is particularly painful given high poverty levels.
While India's inflation runs structurally high, it has been made worse recently by steep rises in agricultural prices after a poor harvest and high dependence on expensive imported oil. The recent rise in the value of India's rupee versus the US dollar should help since it dampens the oil price rise. Price pressure should ease further if a good monsoon, which is forecast with an 80 per cent probability, boosts the agricultural output this year.
In the MENA region, countries such as Egypt, Iran and Saudi Arabia with large populations and infrastructural constraints have historically been more prone to inflation, while underpopulated regions struggling with oversupplied property markets such as the UAE or Qatar should see little inflationary pressure in the medium term. One big exception to the inflation regime is Japan, which has struggled with deflation for more than a decade after briefly reverting to price stability in 2006, slipped back into deflation last year and is likely to stay there for some time given a weak growth outlook, slow credit expansion and weakening demographics.
There is near-consensus that this moribund situation will continue, with analyst forecasts for deflation tightly grouped between 1 and 1.4 per cent this year. Those who argue in favour of high inflation fear the excess money printed in late 2008 and early last year to revive the stalled global economy will eventually boost prices, as has occurred after most periods of loose monetary policy. The commentary this year by Ben Bernanke, the Federal Reserve chairman, signalled a willingness to keep interest rates low for an extended period to secure growth and energise employment.
Countries such as China and most GCC countries that have pegged their currency to the US dollar are therefore forced to import a policy of low rates, even if it is not entirely suitable for their circumstances. While it is debatable whether cheap money will translate into inflation in the next year or two, there is near certainty that if the recovery continues, the rise in emerging market consumption, especially in the populous countries of China and India, will further drive up prices over the next decade for many commodities, industrial and agricultural.
Large gaps between core and headline inflation are likely, especially in those countries where weak demographics and employment limit property costs and wage increases, and consequently drag down a major component of core inflation, but imported food and energy inflation dominates the headline. The inflation sceptics point out that even though monetary policy is loose, its impact will not be inflationary in the short to medium term since credit transmission is still weak.
As well, slack capacity will persist in western economies for the next couple of years, which limits pricing power, and unemployment will remain elevated. Looking further ahead, deleveraging in the western economies is likely to continue for an extended period, after two decades of major borrowing, as consumers remain cautious and demographics weaken. So while it is premature to panic on the inflation front, it is wise to be mindful of the wide disparities of opinion on the inflation outlook for the next year or two.
The further out you look, the greater the consensus among forecasters that inflation will be a problem. As with buying an insurance policy, the price of protecting against inflation is cheapest when you need it least. The premium to be paid for inflation protection is low today but will rise if we see a steady stream of inflation data. So it is a good time to map out a long-term inflation protection strategy and, slowly but surely and selectively, add undervalued inflation proofing assets to your investment portfolio.
Rehan Syed is the head of portfolio management at ABN AMRO Private Banking in Dubai. The opinion expressed is personal and not necessarily that of his employer.