The global liquidity boom is finally turning into inflation through three channels. First, the property boom inspired huge service demand in Anglo-Saxon economies and has led to tight labor markets there.
Second, the commodity bubble of the past three years has increased costs of production and living by over 5% of global GDP. Although commodity inflation has been absorbed through consumer borrowings and lower profit margins in the past, it is now turning into higher wages and core inflation.
Third, China has kept the global cost of production artificially low by not paying for pollution and labor benefits. The political pressure within China is such that the government is normalizing production cost, which could boost global inflation.
Globalization has slowed and stretched macro trends. Inflation is likely to follow the same pattern. Global inflation has picked up by 60 bps in the past four quarters. If the trend continues, as I believe, major central banks will have to focus on fighting inflation with little room for growth considerations. Moreover, this is just the beginning. Major central banks may have to focus on inflation for two years.
Bonds are the first asset class to decline in value in this cycle. The trend is likely to continue, in my view. Declining bonds will eventually take down other assets. In particular, as the yield curve steepens, the commodity bubble can burst. The stock market will probably come down last.
The world would then experience a period of all assets declining in value mirroring what has occurred in the past three years. This period could last for two to three years - afterwards, the bond market would recover first.
Cyclical Inflation Is Coming
Globalization has slowed but not eliminated cyclical inflation. Globalization has stunted wage inflation as the main transmission between monetary growth and inflation. Instead, excessive liquidity has been fueling asset markets to generate demand. As globalization spreads the demand growth around the world, inflation has taken longer than before to show up.
The tech burst, 9/11, and the rapid relocation of factories to China caused sharp disinflation in 2002. The average inflation of the US, Europe, Japan and China decelerated from 3.2% in 2Q01 to 1.1% 3Q02. The deflation scare triggered the Fed to cut interest rates to 1% and the BoJ’s quantitative easing, which led to a massive liquidity boom.
The liquidity boom has worked into demand through inflating asset markets. Property inflation has given Western consumers the spending power. Commodity inflation has given developing economies income to spend. Declining cost of capital from rising stock market and declining credit spreads has allowed developing economies to invest.
Though inflation has doubled from 1.1% in 3Q02 to 2.2% in 1Q06 for the same sample, it remains low against three years of above-trend growth. Further, many would argue that much of the pickup is due to energy inflation and not in core. This argument is less effective than it sounds. Headline and core CPIs must converge towards each other. Unless the commodity bubble bursts soon, core CPI is likely to converge to headline rather than the other way around.
Three Reasons for Higher Inflation Ahead
First, wage inflation may be coming, especially in economies with high current account deficits. Globalization is effective at keeping inflation down when there is good substitution scope between services and manufacturing in labor markets. This effect dissipates overtime. For economies with large current account deficits, this substitution effect is likely to disappear first. Australia’s lingering inflation despite its sluggish economy is a case in point.
Second, commodity inflation has not all hit headline inflation, as companies have absorbed some and governments have subsidized. Brent crude has averaged US$63.7/bbl in 2006 compared with US$25 in 2002. The increased cost for oil for the global economy between the two prices is US$1.2 trillion. Other energy resources (coal and natural gas) have roughly doubled in price during the same period and may incur about US$500 bn more. The extra energy cost is probably 4% of global GDP. A substantial portion of energy inflation is yet to show up in inflation. The inflation of other commodities adds at least another 1%.
Third, China is normalizing its production cost. Manufacturing production has relocated to China on a massive scale in the past five years due to China’s cheap labor and lax enforcement of environmental standards. While the low labor-cost advantage is well understood, the lax environmental rules and their enforcement are not well understood and may have become more important than labor costs in attracting production relocation in the past three years.
The world has dumped its pollution in China in the past five years. According to China’s EPA, China’s pollution is 12 times the world average per unit of GDP. The emission of sulfur dioxide is 22.5 mn tons compared to the maximum carrying capacity of 12 for the country. Two-fifths of the seven major river basins are severely polluted. 90% of the rivers running through cities suffer from severe pollution problems. 300 million rural residents have no access to purified water. One-third of China’s territory suffers from the effects of acid rain. Two-thirds of the population suffers from poor air quality.
China’s environmental catastrophe is a poorly understood factor in the global disinflationary trend. If the relocated factories had to subscribe to the same environmental standards as in the OECD countries, goods made in China may not have been so cheap. My guesstimate is that the lesser costs for pollution have been more important than cheap labor in the disinflationary pressure from China.
China is waking up to the need to normalize pollution costs. Guangdong Province may close thousands of businesses that do not meet environmental regulations. The NDRC just issued tightening instructions on the carbide-based PVC industry that creates serious pollution.
China’s policies to increase wages (see ‘Raising Wages, not Currency’, 12 May 2006) will increase China’s export price substantially, by 20-30% for industries like knitwear. The normalization of pollution standards could do the same for many chemical products.
Normalization of China’s production is a major source of cyclical inflation. Part of the unsustainable disinflation between 2002-05 has to be regurgitated.
A Protracted Bear Market for Bonds Ahead
Global inflation is likely to sustain its trend of ticking up 5-6 bps per month. This slow grind is due to financial globalization that can spread inflation in one country to the world through currency markets and current account balances. The pace may accelerate from here, as the room for labor substitution between service and manufacturing is exhausted in Anglo-Saxon economies.
The slow wage response to the liquidity boom is a unique feature in this cycle. The raison d’être of rational expectation economics is that workers who are also consumers understand that excessive monetary growth will lead to inflation and, hence, demand wage growth when they see above-trend monetary growth. This dynamic has not been working due to two factors. First, outsourcing has increased job insecurity and made goods cheaper. Second, property appreciation and easy credit have made it easier to defend lifestyle with debt.
As both factors exhaust their effectiveness, wage demands could escalate. 2006 may see the revenge of monetarism. While the central case is for inflation to tick up slowly, the possibility exists for inflation to flare up sharply.
Source: Morgan Stanley Research
:) Falkor
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