Despite deteriorating global economic conditions, inflation remains a global concern, not just in Australia.
Recent readings for inflation in both industrialised and emerging countries have been worse than expected. Energy and food prices are the main culprit.
The rise in food prices is giving rise to talk of “agflation” and there is much talk about stagflation. The AMP’s Dr Shane Oliver reports.
Why is inflation a problem for investors?
Inflation is bad for most investments because it undermines real asset values and pushes up the yields that investors require to invest (and so pushes down price to earnings multiples for shares). It reduces the quality of company earnings in the case of shares (because when inflation is high companies under allow for depreciation) and distorts economic decision making. Sustained inflation has generally been associated with sustained lower economic growth/rising unemployment.
The combination of weak growth and high or rising inflation (stagflation) is particularly bad news as poor equity and bond returns in the 1970s attest. So for all these reasons, inflation is bad news for investors and talk that central banks should tolerate a little bit of extra inflation is crazy.
But how big is the global inflation threat anyway?
Food and energy fuel inflation There is no doubt global inflation has picked up. Headline inflation in the G7 economies is at its highest since 1992. Inflation is also on the rise in developing countries.
As in Australia, a common feature driving higher inflation globally has been fuel and food prices. See the next chart.
Oil prices have been rising for several years on the back of strong demand in emerging countries and constrained supply.
Food prices are up for a variety of reasons including bad weather, the impact of the increasing use of rural products in alternative fuel production and rising calorie intake in emerging countries resulting from rising income levels.
Investor demand is also playing a big role in all commodities, with the latest spurt possibly reflecting a view that commodities are now the only asset class with positive momentum which naturally brings with it the risk of a decent correction at some point.
But as can be seen in the first chart, inflation excluding food and energy has also been drifting up lately.
Not the 1970s
The first thing to note is that today’s 3 or 4% inflation rates are simply not comparable to the double digit extremes reached in the 1970s. This can be seen in the next chart.
Wages remain benign
Food and fuel are important items of consumer spending, but they only account for 20% or so of total consumer spending in rich countries (in Australia its 20%). A key the 1970s, one of the reasons inflation became so entrenched was because higher fuel and food costs fed into wages growth, creating a self perpetuating inflationary cycle.
Today there is no evidence of this.
Wage growth in most countries has remained pretty benign. For example, US employment costs rose 3.3% last year and by 4.2% in Australia. With global economic growth slowing it’s hard to see wages growth picking up. Moreover rising fuel and food costs eat into consumer spending budgets, leaving households with less to spend on other things, which is likely to mean downwards price pressure on other items.
China – from deflation to inflation or not?
Over the year to January consumer prices in China rose 7.1%. With China being the epicentre of falling global inflation over the last decade this is worrying. However, there are several things to note. Firstly, it is again being driven by food prices – inflation excluding food is just 1.5%.(See the next chart).
Clothing prices and recreational goods prices are falling.
This contrasts with the surge in Chinese inflation in the early 1990s which was broad-based.
Secondly wages growth in China while strong at around 12% pa is benign compared to nominal GDP growth of around 15% and very rapid productivity growth.
Thirdly, the rise in US import prices from China is due to the fall in the $US versus the Renminbi. Chinese exports to the US in Renminbi are still falling in price.
The level of Chinese export prices remains well below competitors forcing export prices from the rest of Asia down and as China moves into higher value adding production it will push prices down in these areas.
So overall, there is no evidence that inflation is getting out of control in China.
Inflation, stagflation and a normal economic cycle.
Periods of rising inflation and falling growth (stagflation) are a normal phenomenon that occurs every so often in the economic cycle.
Because inflation normally lags growth, there is usually a point in the economic cycle where growth slows but because the level of capacity utilisation and cost pressures are still high inflation is continuing to rise or stays high.
These periods are shaded in the next chart for the US. Of course these periods were more intense in the 1970s.
But because stagflation is a normal cyclical phenomenon there is no reason to get too alarmed by the current spike in inflation pressures.
With global growth set to slow this year it is likely that excess capacity will result in falling underlying inflati
