Inflation Story that Nobody Is Telling You

The vast majority of consumers see “inflation” as what we’re paying for groceries, gas, a Starbucks coffee, and electricity.

Yes, it’s true that rising prices for these necessities has been the poster child for inflation lately. But there’s much more to inflation than just forking over more at the gas station or coffeehouse.

When it comes to Europe, wage push inflation plays a crucial role.

Producers Pass the Inflation Buck

the Consumer

Producer prices are simply the costs required to produce goods and services. Naturally, when producers have to pay higher costs to produce goods, they’ll demand higher prices for the goods they’re selling. In other words, they pass their higher costs to you, the buyer.

Rising commodity prices tend to be a big reason why producers’ costs rise. More money spent in production means smaller profit margins at current prices. If a producer wants to make up for shrinking profit margins but can’t control his input costs, then he must pass on these costs in the form of higher prices. Excess money creation is what drives this type of inflation, affording higher prices.

No doubt, this is exactly why rising energy costs have been such a huge driver of the inflationary environment we’ve trudged through over the last several months.

The debate is heating up among whether this global inflationary period is coming to an end. I tend to believe it is. But, more importantly, economic growth and available credit across the globe is rolling over at the same time surging commodities have left inflation concerns on everyone’s mind.

For this reason central bank policy makers are struggling.

The cost of energy has buoyed the cost for producers, consumers, and everyone in between. But what happens when this pressure eases for a considerable stretch of time?

Inflation Is a Little Bit Different on the Other Side of the Pond

They don’t serve ice cubes in their drinks. They can drive on the left-hand side of the road. And inflation is also a little bit different in Europe. Despite this fact, inflation analysis in these respective regions often focuses on generalities and overlooks one particular difference. Let me explain…

Let’s focus only on two countries and two central banks: The Federal Reserve and the European Central Bank. If you haven’t been hiding under a rock for the last year, then you probably have some kind of idea how their respective policies vary.

The Federal Reserve has knocked off more than 3% from its benchmark interest rate in the last year. In that same time, the European Central Bank has mostly stood its ground, mixing in one rate hike of 25 basis points that brought its benchmark up to 4.25%.

And if you’ve been following my currency articles lately, you also probably know that this monetary policy discrepancy has been a boon to the euro, and a detriment to the buck. For many months, even years now, the relative performance of each currency has been primarily based upon expectations for this rate differential to change.

As you might imagine, inflation expectations play an enormous role in monetary policy expectations. Even though inflation has received plenty of attention over the last several months, many analysts have neglected an important difference between European inflation and U.S. inflation.

Now’s the time to pay closer attention.

What All the Analysts Have Missed Over the Last Few Months

In the last few weeks, commodity prices (particularly crude oil) have cracked. With that abrupt downturn also came a reprieve in inflation expectations. And that’s got many accepting the potential for a lasting shift towards even lower prices and less inflation pressure.

With that in mind, the dollar has managed to rally on two simple facts:

1. The U.S. Federal Reserve has already lopped off a considerable portion of its benchmark interest rate. So they’re now ahead of the rate-cut curve, which has helped maintain some growth in the U.S. relative to Europe.

2. The European Central Bank will be forced to bailout their deteriorating economy by cutting their benchmark interest rate.

Up until this point, the European Central Bank had a good reason to keep fighting inflation. But with commodity prices easing up, now may be the time for ECB policy makers to take action. Here’s why they’ve struggled…

Why Hasn’t the ECB Joined the Worldwide Rate Cutting Party Yet?

With many threats to global growth and concerns over several Eurozone member countries, many have been surprised the ECB has gone so long without letting up on the interest rate front. After all…

• The Federal Reserve has made several moves to lower rates
• The Bank of Canada has followed suit
• The Bank of England has gotten the ball rolling
• So has the Reserve Bank of New Zealand
• The Reserve Bank of Australia is likely next

If you’re wondering why the ECB hasn’t budged, look no further than labor unions. Simply put: Wage contracts put in place via labor unions have employees’ wages moving higher in lock-step with inflation.

There’s really no thought to profitability (the point when workers typically consider demanding higher wages). In other words, rising headline inflation fuels this wage-spiral. And this wage-spiral spurs greater headline inflation. And it continues on like this. That’s something Ben Bernanke hasn’t had to deal with.

You see, the Fed has been able to react to weakening growth by cutting interest rates. The plan: As growth moderates, or rolls over, inflation is likely to follow. But that assumption is more difficult to make when you’ve got rising wages keeping prices unnaturally high. The ECB hasn’t yet been able to make that assumption. Its interest rates remain high.
But here’s what you should expect…

When the ECB finally decides to cut rates, they will do so substantially and they will do so quickly. It will be their way of reloading. Because we know, with the labor unions continually eroding profit margins and forcing prices higher, the ECB will need some fire power for their next inflation shoot-out.

If they cut back rates now, they’ll be able to hike rates and combat inflation when the time comes again. All you need to do is be prepared to act accordingly.

15 2008 - Australasian Investment Review – (AIR)

Suddenly the spectre of inflation no longer hangs over the world: it’s gone, banished by the reversal in sentiment in commodity and financial markets. Banished by fears of recession, which were confirmed overnight with Europe contracting in the second quarter, with Germany and France following Italy into a slump. Oil, copper and gold down, and wheat, corn and soybeans as well it’s been a sea change in sentiment in the past month. Slowing Europe and Japan suddenly mean the US is not alone, so it’s off into the greenback because you’ll be more protected there. Europe moved into a real slowdown in the June quarter,with growth contracting by 0.2%, Germany’s economy contracted by 0.5%. France slowed as well, with the economy falling a surprising 0.3% in the quarter. Growth is still up for the first half after the March quarter saw growth of 0.7%, but the size and speed of the slump was surprising, and emphasised why commodity prices are weakening, along with the euro. Inflation is supposed to have peaked, or is close to peaking; growth is slowing, and so will price pressures as recession bites. That’s why the surge in consumer inflation last month in the US came as a complete shock to the markets. Despite the slump in oil and petrol prices from mid-month onwards, and the rise in the value of the US dollar, the CPI surged by a rather large 5.6%, the highest rate since January, 1991 when the first Gulf War was raging. That compares to an annual 5.1% in the year to June. The CPI rose 0.8% in July, compared to June when it jumped 1.1%, so there was a small slowing. But the surprising news had no impact on interest rates, shares or sentiment. Oil was still easier, gold fell sharply, losing the gains of the day before and copper was lower. Higher food, petrol and energy costs were responsible, despite the drop in oil and petrol prices. Those falls are continuing, that’s why economists believe the CPI will drop sharply this month. Now the older and wiser of those in the market wonder if there’s something more dangerous approaching, along with the slumping global economy: deflation. More of that shortly. All year long, the debate has raged over whether the world faces a greater risk from resurgent inflation or from a deflation, caused by the credit crunch, to match Japan in the 1990s. The fall in commodity prices has, for now, convinced the market that we need not worry about inflation. In the US, the market for government inflation protected bonds (called TIPS) now implies that inflation will average 2.16% over the next decade. That’s the lowest in five years, but is it just as much an overshoot as the upward drive in commodity prices when they peaked midway through last month? What is still clear is that inflation is still with us: from the United States, through Europe and Asia, prices are still rising. Wholesale price inflation is double digit in China (but consumer prices are easing); in the US, Europe and the UK wholesale and consumer price inflation are at levels not seen for more than a decade in some cases.  In Japan this week’s report of a 7.1% jump in wholesale inflation was the steepest rise in 27 years In the eurozone, the consumer inflation hit 4.0% in July; more than double the European Central Bank’s inflation target of 1%-2%. Inflation stands at 3.6% in France, at 4.4% in Britain (its highest level for 16 years) and at its highest level for 12 years in Italy at 4.1% and 11 years in Spain where its running at 5.3%. In Germany inflation hit 3.3%, the highest rate since 1993 and enough to get the old anti-inflationist Bundesbank rolling in its grave. Inflation hit 4.3% in Norway, Eastern Europe it’s 6.7%, while in India it’s running at nearly 12% and in Japan at 1.9%, the highest for more than a decade. In some countries such as Argentina there’s doubt about the declared rate (9.3% there) because of changes to the way the government accounts for and reports inflation. In Thailand it’s running at 27% and higher in Egypt This week China reported a slowing in consumer inflation to 6.3% from 7.1% in June. But core measures which discount food and energy have risen past 2%. Now the point of this international roll call is to make a point: normally it would be enough to see interest rates rising everywhere: in India, the central bank is tightening policy, but apart from the increase at the start of July by the European Central Bank, central banks are holding back, transfixed in the case of the Fed and with the Bank of England by fears of a downturn and fears about inflation. So why then are financial markets (even bond markets) suddenly more relaxed about price pressures and galloping into equities and out of oil and commodities? Relative growth differences between the US, Asia and Europe is the one reason already stated, but the Merrill Lynch’s August fund managers survey provides a second reason. Big international investors no longer fear inflation.They worry more about recession, which they believe will take care of cost pressures.So does that indeed signal a deflationary period of rapidly falling growth and prices?

 

Here’s what Merrill Lynch concluded this week:

Fund managers’ fears of inflation have all but evaporated to reach their lowest level since the downturn of late 2001, according to Merrill Lynch’s Survey of Fund Managers for August.

Merrills said a total of 193 fund managers participated in the global survey from 1 August to 7 August, managing a total of $US611 billion. A total of 161 managers participated in the regional surveys, managing $US432 billion.

The survey captures an extraordinary reversal in investors’ attitude towards inflation. A net 18% of the 193 respondents expect global core inflation to fall in the coming 12 months.

In June’s survey, a net 33% thought inflation would rise.

A falling oil price and growing evidence of recession have prompted this rethink.

More investors believe that the global economy has already entered recession - 24% of the panel take that view this month compared with 20% in July and 16% in June. During the credit boom, investors urged companies to borrow more, but with the credit crunch biting, they are now concerned about leverage.

The net percentage of investors who believe corporates are under leveraged has tumbled to 9%, down from nearly 40% at the end of 2007.

“The message from investors to corporates is that if we are headed for a recession, they should clean up their balance sheets and prepare a financial buffer,” said Karen Olney, chief European equities strategist at Merrill Lynch.

“As banks de-lever, non-financial corporates will have to wake up to far less flexible world of credit.”

Merrill Lynch found that US assets are indeed back in favour (as it seemed in the Mat survey).

“With the economic downturn spreading to the eurozone and certain emerging markets, investors are starting to view U.S. assets as attractive.

“The net balance of asset allocators overweight U.S. equities stands at 12 percent, its highest level in more than six years.

“Supporting this view is the widely-held belief that the U.S. dollar is undervalued.

“A record net 58 percent say this month that the dollar is undervalued, while a net 71 percent say the euro is overvalued. Investors believe that the U.S. has a better corporate profit outlook and higher quality earnings than the eurozone.”

In Europe, investors are moving from oil to consumer stocks.

“European investors have responded to the fall in the oil price by selling oil producers and buying into discretionary consumer stocks.

“The percentage of European investors overweight oil & gas stocks collapsed to 11 percent in August from 52 percent in July.

“Investors have also significantly scaled back large underweight positions in travel & leisure, personal & household goods and retail companies.

“Technology and media sectors, both with significant exposure to consumer demand, also swung back in favour.

“At the same time, inflation fears among the European panel have fallen to levels even lower than in the Global Survey.

“A net 45 percent of European fund managers expect the region’s core inflation to fall over the next 12 months. In June, 32 percent of the European panel were predicting rising inflation.

“The market appears to have overreacted to a fall in the oil price, and investors have turned a blind eye to second round effects of inflation, such as rising wages,” said Karen Olney. “It will take several months of slowing global growth to be sure that the inflationary dragon has been slain.”

But the Merrill Lynch survey contains a cautionary note.

“One consequence of the recent fall in the oil price has been a rapid unwinding of what the survey has highlighted as a highly-crowded trade: Investors have reduced ‘long’ or overweight positions in energy and started closing underweight positions in financials.

“But have they lost sight of the fundamentals in unwinding this position?”

Merrill Lynch says it believes that the energy sector will continue to be supported by a strong oil price.

The firm forecasts oil at $US119 in the fourth quarter, underpinned by low, real global interest rates.

Francisco Blanch, Merrill’s head of global commodities research, said in a statement with the survey results: 

“While we have started to see some demand for oil curtailed in OECD economies, the economic fundamentals in China and other emerging markets support oil at more than $US$100 a barrel into 2009.”

“Investors have moved to close underweight positions in European financials after second quarter results suggested banks are on the road to improvement.”

But, according to ML’s Stuart Graham, head of European bank equity research, toxic write-downs are coming to an end and banks have completed more than half of their capital raising.

However, although earnings downgrades for banks are well under way, doubts remain about the sector’s ability to bounce back quickly.

“Banks are highly unlikely to see a V-shaped recovery in their share price given the uncertainties in the market,” said Stuart Graham. “Apart from the economic outlook, a key question is how stringent regulators will be in setting new rules to govern banks’ capital ratios. No one yet knows what the appropriate capital structure of the future is.”

 

 

The contrast was telling: there was India’s central bank sending a strong signal that it will not tolerate high inflation by announcing a larger than expected increase in its key lending rate and threatening more measures to come.

And there was US ratings agency; Standard & Poor’s lifting China’s credit rating one notch to A-plus from A, despite all the poor publicity about the Olympics.

They are not directly related, but they do point to the de-coupling going on in the so-called cornerstones of the emerging economies. 

China, for all its problems is still travelling fairly well with growth and exports slowing, but inflation falling; India is gripped by surging inflation and falling growth.

Surging oil prices and subsidies are undermining the Government’s economic record and boosting inflation, in China firm price controls remain in place, but a black market continues and when the games finish, the question is whether the controls will be relaxed.

And if that happens, will inflation return to the upswing, from the present 7.1% annual level?

But Standard & Poor’s said it upgraded China’s debt ratings because of the improved fiscal and external positions in the world’s fastest-growing major economy.

The long-term sovereign credit rating was raised to A+, the fifth highest on its scale, from A, and the outlook is stable. The short-term rating was increased to A- 1+, the highest notch, from A-1.

That means China has the same short term rating as the heavily indebted US economy.

“The ratings upgrade is motivated by China’s improving fiscal and external position,” Standard & Poor’s said in a statement.

China’s economy grew 10.1% in the second quarter from a year earlier, but that was the fourth straight quarter of slowing growth as exports slowed.Growth ran at 11.9% last year

But in India a very different story, for all the positive news about growth and business opportunities.

The Reserve Bank of India’s increase in the benchmark “repo” rate by 0.50% to a seven-year high of 9% represents the third time in two months that the bank has raised interest rates to try and bring inflation under control.

Inflation is at a 13-year high of nearly 12%, much higher than China, or its other emerging economy rival, Brazil.

The RBI also increased the cash reserve ratio by 0.25% to 9%. 

That’s the amount of funds banks must keep on deposit at the central bank and is the same mechanism China’s central bank is using to try and slow activity. China’s rate is around 17.5%.

The Reserve Bank of India cut its forecast for economic growth this financial year by 0.50% to 8%.

Rising oil and food prices have given India a big headache with inflation that is nearly triple its levels at the beginning of the year and more than double the RBI’s target of under 5.5%.

A national election has to be held before May next year and the government has been under pressure from bans on exports of essential food items and raw materials and cancelled futures trading of important commodities to try to rein in prices. 

These moves have been done to try and hit inflation, but they seem to have backfired, as inflation has risen regardless of these attempted control measures.

RBI governor Yaga Venugopal Reddy said in the statement that it was critical to demonstrate “a determination to act decisively” against inflation.

But he said he was confident India could still sustain a relatively high rate of growth of 8%, which doesn’t seem to be possible, given what’s happening in the wider economy.

The Governor has lowered his forecast by one percentage point to 7.2% for the year ending March 2010 and the central bank conceded that it had lost ground in its battle against inflation, saying while it would prefer to see it at 5%, while a more realistic target for the end of the March 2009 financial year would be 7%.

The RBI has been raising borrowing rates since 2004 to try and control cost pressures.

India’s inflation rate is 11.91% as higher prices of gasoline and diesel fed into the economy.

The central government will pay around $US43 billion in oil subsidies, even though it has allowed prices to rise by a small amount.

Standard & Poor’s said this month that India’s BBB- credit rating, the lowest investment grade, may be cut to junk if the faster inflation and higher government spending ahead of the election increases the budget deficit.

The Indian government has waived $US17 billion of farm debt and kept those oil subsidies.

There’s a long way from India’s rating and China’s which now reflects that it is approaching advanced country status.

Friday it was inflation hitting a high of 1.9%; last Wednesday it was June exports falling 1.7%, the first such decline for five years; yesterday it was news that Japan’s unemployment rate had hit a two year high. More and more evidence is emerging that the world’s second largest economy is in contraction mode, and it is going to get worse before it gets better. Figures were also released yesterday showing that Japanese household spending fell last month. Economists say the signs are getting stronger that the country has slowed to what’s called a ‘growth recession ‘ at best, and at worst, is contracting. The fact that inflation and employment, two economic indicators with the longest lag effects, are now rising in a markedly pessimistic direction, bodes ill for the next set of official estimates about growth. Some economists in Tokyo are speculating that the economy contracted at an annual rate of half a per cent, or more in the June quarter. The Bank of Japan has cut its outlook for the economy twice in four months, the most recent around 10 days ago.  It said then the economy was slowing “further” because of weak business investment and consumer spending. Growth is now estimated at around 1.2% for the year to next March from the April estimate of 1.5%. The unemployment rate hit 4.1% last month, from 4% in May, according to the Japanese Government statistics bureau. The total number of unemployed in June was 2.65 million, up 240,000 from a year ago, and the third consecutive year-on-year increase. Household spending fell 1.8% in June from June in 2007, the fourth monthly drop and follows the surge in oil and food costs that pushed core inflation to 1.9% last month, a decide high, the bureau said. The marked downturn in corporate confidence shown in the June quarter’s Tankan survey from the Bank of Japan has been confirmed by the flood of figures. Car sales are falling and car exports are falling. Toyota and Honda have both warned that it will be tough in coming months: Toyota Monday cut its output estimate for global sales, and especially sales in Japan and the US. June’s jobless rate was the highest since September 2006 and the number of vacancies fell to their lowest ratio since the start of 2005. Retail sales rose 0.3% in June from June last year, but that was more due to the soaring cost of petrol and food than higher actual demand.

 

The car companies are the best barometer at how the country’s domestic and export economies are travelling, and there’s no better individual litmus test than what Toyota sees. It’s gloomy.

On Monday it cut its 2008 global sales forecast by 350,000 vehicles to 9.5 million and blamed sluggish North American sales, especially in the US.

Even with the new, lower estimate, Toyota plans to sell more vehicles than it did last year: a mere 1% more though, compared to the 5% rise in worldwide sales in 2007.

The pace of Toyota’s growth has been slowing. Under the new target it would inch up 1% this year, in contrast to a 6% climb in 2007, when it sold 9.37 million vehicles. It originally planned to sell 5% more vehicles in the year at 9.85 million units.

Besides the slowing US and other markets in Europe and Japan, rising steel and other raw material costs (plastics) is hitting the company’s profit margins.

Toyota said sales were still solid to China, the Middle East and these other markets will be enough to maintain worldwide growth this year, albeit at a much smaller rate.

Toyota now plans to sell 2.44 million vehicles in the US, less than its December ambition to sell 2.64 million vehicles. Overall sales to North America were also cut to 2.67 million vehicles from 2.84 million.

The new estimate is around 5%-7% lower than its 2007 sales result of 2.62 million vehicles for the US and elsewhere in North America.

Other car news Monday from the US showed that General Motors had cut its 2008 production by another 117,000 vehicles, all gas guzzlers like pick ups and SUVs. Toyota is slashing its production of these vehicle types and switching one of its SUV plants to produce the hybrid Prius within two years.

Brokers in Tokyo reckon Toyota’s first quarter earnings might be down 30%-40% when the company reports them on August 7. For that you can blame the US and the sluggish Japanese market.

In another sign of the problems the economy and exporters are having, the mighty Sony consumer electronics business saw a sharp drop in earnings in the latest period.

Sony is the world’s second-biggest consumer-electronics group and it said the June quarter profit dropped for the first time in five quarters because the stronger yen eroded earnings and competition forced the company to cut the prices of its new Bravia range of TV products.

The company said net profit fell 47% to 35 billion yen (or $US326 million) from 66.5 billion yen in the June quarter of 2007.

The company cut its full-year profit forecast by 17% to 240 billion yen.

Sony shares dropped 3.2% yesterday ahead of the announcement: they are off 32% this year on fears the stronger yen and sluggish Japanese and US economies would hit earnings, which they have.

Sony’s mobile phone joint venture with Ericsson is also doing poorly. That hurt earnings in the quarter

Yes inflation remains a problem in Australia, and no it won’t mean higher interest rates, not when the banks have added more than half a per cent to the Reserve Bank’s 1% of increases in the past 11 and a half months. And, not when oil prices have risen so far,and maybe now on the turn. It was in August of 2007 that the bank commenced its latest round of rate rises to try and nip what it knew was an outbreak of inflation occurring from our booming resource economy. That rate rise came on August 4: five days later the credit crunch arrived and hasn’t left us: the bank lifted rates three more times, each by 0.25%, but in January the banks started adding extra increases, and then more rate rises when their cost of funds rose as the crunch ended the easy money days and lifted all rates across the world. Inflation still rose, but since March the RBA has sat and waited for its increases and those from the banks to work their way through the system: suddenly oil prices, which had been rising through $US80 a barrel late last year, and then through $US90, and then $US100 a barrel, took off in the June quarter and hit a peak of $US147 and change. Retail and housing slowed, car sales eased in the June quarter and now TV advertising has stalled with no real growth in the June half and the RBA realised that the surge in oil prices had delivered the equivalent of one, perhaps two more rate rises of 0.25%, strangling demand, forcing up costs and hurting the entire economy. That’s why it has been warming us up for a big inflation rise in the June quarter, and why it has been telling everyone, in its opaque central banker way, that it will wait and see what happens. The bank knows the economy has been hit with two massive shocks: the most brutal tightening in monetary policy in decades with a rise of more than 1.5% in all rates (and more for some clients of non-bank lenders) and now the huge increase in oil prices. That’s why the 1.5% rise in the headline Consumer Price Index in the June quarter, to produce an annual rise of 4.5% in the 2007-08 financial year, won’t bring a rate rise when the RBA board meets Tuesday week. The Australian dollar edged higher, but not by much, while the stockmarket built on early gains after digesting the news. According to figures from the Australian Bureau of Statistics they were the highest quarterly and yearly figures for 13 years, the GST-induced increases in 2000 and 2001 excepted.

 

As expected it was higher fuel (especially petrol) costs, housing and most financial services (the impact of the extra rises from the banks), which were the main culprits. Food costs eased in the quarter.

Some excitable commentators had pushed the line in recent days that a smaller than expected rise could be possible, given the slowdown in the domestic economy.

The surge from higher oil and fuel costs, financial services and housing meant the figure was always going to be high, but not even market economists reckoned on the 1.5% rise for the quarter as the median forecast was 1.3%. Food costs eased 0.1% in the quarter, thanks to a surge in supplies of fruit and vegetables, a point remarked upon by Woolworths in its 2008 sales figures report last week.

The latest figures compare to the 1.3% rise in the March quarter and the annual rate of 4.2%.

Our annual rate of 4.5% is high: the US rate in the year to June was 5.0%, the UK had an annual rate in the same period of 3.8% and inflation is running at a 3.7% rate in Europe.

The quarterly and yearly rises were the highest since 2000-01 when the impact of the introduction of the GST rippled through the economy. Apart from that, the June headline figures were the highest since the first half of 1995.

But the Reserve Bank won’t change its neutral stance on rates. 

It has been warning the market for the past six weeks to expect a larger than normal increase in the CPI for June because of the impact of higher fuel costs (the RBA said higher petrol prices would add 0.25% to the June and September quarter CPIs) and sending a signal that such a rise would not force a rate rise when the board meets in early August.

As well the bank sees the extra rate increases from the bank (more than half a per cent) as further tightening monetary policy on top of its 1% increase in the cash rate to the current level of 7.25%.

The bank’s own measures showed an increase, but are now in line with the headline increase.

The RBA’s Weighted Mean measure rose 1.0% in the June quarter (compared to 1.3% for March quarter) and 4.5% for the year (4.4% in the year to March).

On a trimmed mean basis the quarterly CPI rose an unchanged 1.2% on the March quarter, to be up 4.3% from a revised 4.0% (4.1% originally).

Even though they are well above the RBA’s 2% to 3% annual rate target (over time), there are signs of some slowdown; signs that were also seen in the produce price indices for the June quarter which were released earlier in the week.

There were also some worrying signs” non tradable goods inflation jumped by more than 5%, while tradable goods inflation was lower (because of the influence of the strong dollar). For more details on what drove inflation to these levels in the quarter, see the story below.

 

 

“Inflation is likely to remain relatively high in the short term, and the consumer price index will be further boosted in coming quarters by the recent rises in global oil prices.”

With that statement, the Reserve Bank has signalled that we are in for a period of high inflation, much longer than previously thought, and as a result interest rates will remain at current levels for much longer than previously thought as oil price driven inflation works its way through the system.

The warning was issued in the statement after the RBA yesterday left its cash rate unchanged at 7.25%.

The warning that inflation will rise in coming quarters and won’t ease until oil prices (and other cost inputs, such as food) drop, was very different to what it had been saying after previous meetings.

Then the bank said inflation was expected to remain high before moderating. That moderation is still expected, if the slowdown continues, but it will take much longer to happen.

Just how long a period is uncertain, but it could be well into 2009 before there’s any hint of a rate cut. Anyone thinking of the first half is being optimistic, unless there is a sharp contraction in the economy.

In the meantime if the surge in cost pressures starts producing higher wages or a reversal of the recent slowdown in consumption, rates will rise.

Investors and companies now face growing pressure on margins from the longer than expected period of high inflation and high interest rates.

“As a result of earlier decisions by the Board, additional rises in market interest rates and tougher credit standards for some borrowers, there has been a substantial tightening in financial conditions since the middle of last year.

“Conditions in international financial markets remain difficult, with credit concerns resurfacing in the past month.

“The evidence is that the tightening in financial conditions, in conjunction with other factors including rising fuel costs, is working to restrain demand. Indicators of household spending have recorded subdued outcomes over recent months, and credit expansion to both households and businesses has weakened significantly.

“There have also been some tentative signs of an easing in labour market conditions.”

While the bank again warned of the potential difficulties the rise in Australia’s terms of trade (currently occurring) could cause by working in the opposite direction to monetary policy, it also expressed concern about the danger that “rising prices of oil and a range of other commodities are adding to global inflationary risks”.

“Given the opposing forces at work, considerable uncertainty remains about the outlook for demand and inflation. On balance, while the inflation outlook remains concerning, the Board’s assessment continues to be that demand growth will be moderate this year.

“The most recent flow of information has given additional support to that assessment. Inflation is likely to remain relatively high in the short term, and the CPI will be further boosted in coming quarters by the recent rises in global oil prices.”

“Looking further ahead, inflation in both CPI and underlying terms should decline over time, provided demand continues to evolve as expected.”

So that means unemployment will have to rise further, retail spending and home building will have to continue at present recessed levels for much longer and consumer confidence will have to remain hesitant to unconvinced.

We will get an update on the course of retail sales and building approvals later today with May figures from the Australian Bureau of Statistics, and tomorrow we will get the May trade figures which should reveal the first significant boost from the higher coal and iron ore prices that will lift our terms of trade this year. 

Australia could go close to reporting a trade surplus for the first time in more than six years.

Employment fell in May for the first time in 18 months, but the bank will want to see more than 19,000 or so jobs lost (May’s figures) and the unemployment rate well above 5% (and remember Prime Minster John Howard said he wanted to see the unemployment with “a three in front of it” in the November 2007 election campaign).

 

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Meanwhile the effects of the RBA’s anti-inflation campaign (plus the added 0.40% from major banks on their mortgages) was seen yesterday in figures from the Housing Industry Association.

It said new homes sales fell 5% in May, which was a sharp down from the 0.1% decline in April.

The HIA said sales of new detached houses dropped 5.3% following a 0.2% fall in April, while multi-unit sales tumbled 4.8%.

HIA Chief Economist, Harley Dale, said in a statement that “New home sales results for 2008 to date confirm a renewed cyclical weakness evident across a range of leading housing indicators, a finding that should surprise nobody given the aggressive tightening in monetary conditions seen over the last 12 months”.

Not surprisingly, NSW led the decline, with home sales falling 9.4% in May. Victoria saw a 6.8% drop for the month and Western Australia a 4.9% fall.

South Australian homes sales were down 2.7%, while in Queensland, they were off 2%.

 

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And June saw the first contraction in Australian manufacturing activity in five months according to the latest Australian Industry Group/PricewaterhouseCoopers performance of manufacturing index.

It fell 4.2 index points to 47 points in June, which signifies a contraction.

The number was below the 50 point level, which separates an expansion from a contraction, for the first time since January.

Australian Industry Group chief executive Heather Ridout said in a statement the easing in manufacturing activity was not unexpected.

“Pressures on manufacturers from factors such as the high dollar and interest rates and the weaker global economy are being compounded on the supply side, by rapid increases in the costs of fuel and other key inputs such as steel and agricultural goods,” she said.

“As well, exporters are still finding it tough in this appreciating Australian dollar environment.

“Economic policy will need to strike a fine balance between engineering a slowdown in inflation and avoiding too sharp a slowdown in economic growth and employment.”

The resources-boom state of Western Australia reported a strong rise in activity, but the story was gloomy in the rest of the nation.

The survey showed that manufacturing activity expanded in just two sectors in June, compared with six in May.

The survey showed that production, employment and new orders fell sharply in June but inventories remained solid.

Food & energy are the main drivers of the rise in inflation right now, although price pressures are broader in parts of Asia and Australia.

The AMP’s Dr Shane Oliver says inflation and stagflation worries over the next few months will add to the volatile ride for financial assets.

“However, our assessment is that inflation will decline as growth slows and as oil prices fall in the next six months. As a result market expectations of interest rate hikes are overblown. And signs of lower inflation and lower bond yields should help share markets to rebound from later this year.”

This week he looks at the rising dangers (for the moment) from higher inflation.

 

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Concerns about the global credit crunch and the US housing slump have been supplanted by worries about global inflation.

This is evident in surging bond yields and tough anti-inflation talk from central banks.

For investors rising inflation is bad news, particularly if it becomes entrenched.

High inflation undermines real asset values, pushes up the yields investors require to invest, reduces the quality of company earnings, distorts economic decision making and ultimately leads to lower economic growth & rising unemployment. But how real is the threat?

 

Reasons for concern

While today’s inflation rates are way below the double digit levels of the mid-1970s, there are reasons for concern.

Inflation is above target in most rich countries, it is up virtually everywhere & it is leading to a rise in inflation expectations which threatens second round effects.

Inflation is up virtually everywhere.

 

Key drivers

Surging food and energy prices are the common factor behind rising inflation worldwide. Eg, in the G7 economies average headline inflation is above 3% but core inflation (i.e., excluding food & energy) is still around 2%.

However, in Australia, the problem has been broader than just oil and food. Inflation excluding petrol and food was 3.2% over the year to the March quarter and the Reserve Bank’s measure of underlying inflation was running at 4.3%.

Nor can imported inflation be blamed – prices for items determined in globally rose 3.3% over the year to March whereas prices for items determined in the domestic economy rose by 5%.

It would seem that the boost to national income from surging commodity prices has flowed through to domestic spending which has allowed price increases to flow through in a broader range of areas. Asia has also seen a more broad based pick-up inflation.

Higher food prices have had a greater impact because they typically have a 30% weight in Asian consumer price indices (versus 15% in rich countries).

More fundamentally though the combination of strong demand, waning excess capacity from the late 1990s Asian crisis and undervalued exchange rates have seen underlying inflation rise as well in several Asian countries, although not so far in China.

 

Reasons to expect inflation to fall over the year ahead

Inflation is likely to remain high over the next few months. This and attendant stagflation talk is likely to provide an ongoing source of jitters for share markets in the very short term. However, it’s hard to see it going too much further.

The first thing to note is that, despite the surge in food and energy prices which also occurred in the 1970s there are big differences between now and then which should prevent high inflation becoming entrenched.

We haven’t seen the huge productivity zapping expansion in government that occurred into the 1970s.

The global economy is now far more competitive following the end of the Cold War.

Labour markets are generally deregulated, union membership is down sharply and centralised wage setting in Australia is a thing of the past. Independent central banks have taken monetary policy away from politicians and inflation targeting helps anchor long term inflation expectations.

And financial market deregulation now means the consequences of allowing high inflation become quickly apparent in higher interest rates or a falling currency.

Secondly, the downturn in global growth now underway will likely lead to lower inflation over the next year as excess capacity is freed up.

Every major economic downturn in recent times has led to lower inflation. This is illustrated for the US in the next chart.

This will also be the case in Australia, where a sharp slowdown in a whole array of economic indicators – housing finance, housing starts, consumer and business confidence, retail sales, car sales, employment, etc – indicate that the RBA is now getting the downturn that it has sought.

If history is any guide this will lead to lower inflation.

Thirdly, one of the reasons inflation became so entrenched in the 1970s was that higher fuel and food costs fed into wages growth, creating a wage price spiral.

Today there is no evidence of this. Wage growth in most countries has remained pretty benign.

With economic growth slowing it’s hard to see wages growth picking up. This is certainly the case in Australia where the softening labour market means that the risk of a wages breakout is rapidly receding.

Fourthly, we are likely to see some short term relief in food and energy prices. The past few years have seen rolling manias in various commodity prices give way to a period of range trading.

This was first evident in base metal prices which have now been range trading for two years.

Agricultural commodity prices after going exponential into early this year now seem to have entered a range trading period. While oil is still in the blow-off phase it’s likely that it too will soon enter a range trading environment as slowing global growth cuts into oil demand leading to an unwinding of speculative positions.

We see the oil price falling back to about $US100 a barrel sometime in the next six months and this will cut headline inflation rates substantially.

Finally, the global rise in bond yields on the back of inflation worries has come at a very bad time.

Higher bond yields are boosting fixed rate borrowing costs (US mortgage rates are little different from when the Fed started easing last year!) which will make it even harder for housing markets and the flattening US yield curve (as short term interest rate have risen faster than long term rates) will put more pressure on struggling US banks because they borrow short and lend long.

This will all add to the downward pressure on global growth which in turn will flow through to lower inflation.

So for all these reasons we see inflation falling over the year ahead – both globally and in Australia. As a result it’s unlikely that central bankers will raise interest rates to the extent now priced into financial markets, if at all. The ECB may be the exception, but it’s hard to see a tightening any time soon in the US.

The Fed has rarely tightened when unemployment is rising. And we remain of the view that the RBA has done enough to ensure that inflation will head back to target on a reasonable time frame.

If anything it has probably done too much. The slump in demand indicators suggests that the economy has reached a tipping point and that the negative forces of higher interest rates and high petrol prices are overwhelming the positive impact of high commodity prices and tax cuts.

The risk of a hard landing is now significant. Talk of another RBA rate hike is crazy and the next move will be a rate cut.

This would all suggest that bonds on current elevated yields are providing good buying opportunities.

And signs of lower inflation, lower oil prices and lower bond yields should underpin a rally in shares from later this year.

 

Concluding comments

There are a number of longer term issues regarding inflation, including whether Asia is becoming a source of global inflation and the implications if Asian countries allow their currencies to strengthen to combat inflation, which will be a topic for another day.

However, our key conclusions are that the next few months are likely to remain challenging for share markets as inflation and interest rate worries add to concerns about weak growth but that later this year we see inflation concerns abating in lagged response to slower growth and also as oil prices fall back.

This should be positive for shares into year end.