Inflation Is A Serious Problem, Or Is It?

Source : The Business Times, April 23, 2008

IMF's global measure shows the rates have been relatively good in recent years

IS INFLATION a problem? This is one of the key global issues at the moment. In recent years the world economy has boomed, but that boom did not trigger the type of inflation that one might normally have expected with rapid economic growth.

Meaty issue: Asset prices are falling in many places, instead we are seeing a rise in the relative prices of some food and energy. Food accounts for a large component of the main inflation measures in countries such as China

Instead, most headline rates of inflation around the world have stayed relatively low in recent years. Now, in most countries, headline rates of inflation are rising, despite intense global competition, as food and energy prices rise.

The International Monetary Fund's (IMF) measure of global inflation provides a good insight into the recent favourable inflation environment. According to the IMF, consumer price inflation in the emerging and developing countries averaged 51.4 per cent during the 1990s, but in recent years has been only 6.6 per cent (in 2003), 5.9 per cent (2004), 5.7 per cent (2005), 5.4 per cent (2006), rising to 6.4 per cent in 2007.

Thus current inflation worries need to be put in the context of what went before. Even allowing for this, there is no room for complacency. The IMF expects 7.4 per cent consumer price inflation this year, decelerating to 5.7 per cent in 2009 and 4.5 per cent in 2010. This is low. Many regions have seen dramatic improvements over recent decades, such as Africa and Eastern Europe.

Developing Asia, meanwhile, saw relatively low inflation through the 1990s of 8.6 per cent, decelerating in the early part of this decade before picking up in recent years from 3.8 per cent in 2005 to 4.1 per cent in 2006 and 5.3 per cent in 2007, and the rate is expected by the IMF to reach 5.9 per cent this year.

The IMF includes Hong Kong, Singapore, Korea and Taiwan in advanced economies, whilst China and other Asian economies are included in developing Asia - this definition breakdown does not alter the overall picture.

For the advanced economies, consumer price inflation averaged 3.0 per cent during the 1990s, and the highest it has reached on an annual basis this decade was 2.4 per cent in 2006; but this year the IMF is expecting 2.6 per cent, led by the US.

The GDP deflator, a broader measure of inflation, shows a similar trend for the industrialised economies, albeit at slightly lower rates.

Many factors accounted for this period of relatively low inflation in recent years. One of the key ones was the world boom that occurred after a period of relatively moderate growth, and thus there was ample spare capacity in the world economy.

China factor

That is, there was plenty of scope for growth to accelerate before any bottlenecks were hit. Another factor was the emergence of China. The shift of global manufacturing from the West to the East has been an ongoing feature of recent decades which have seen Asia move from producing cheap, low-quality goods to producing cheap, but much higher-quality, goods.

China has resulted in a flood of cheap goods and has ensured the scale and pace of change is far more dramatic. And despite the appreciation of the yuan, these goods are still much cheaper than the places in the West in which they might previously have been produced.

The share of world GDP that is moving to the developing world is rising. Indeed, I have often said that CPI figures (consumer price indices) should have been renamed China Price Indices, such was the impact of China!

China's increased production of cheap goods has had a profound impact on global competition too, forcing firms around the world to squeeze further savings out of their supply chain. This is still an ongoing development.

Another vital factor contributing to low global inflation has been the credible macro-economic policy environment. Take Africa, for example, where a decade ago high inflation, depreciating currencies and high interest rates were typical of most countries. Now currencies are more stable, rates lower.

But, more generally, in many countries around the world, political parties on the Left and the Right have often adopted similar, anti-inflationary monetary policies.

Yet, the picture was not that clear-cut. There has been much debate about whether inflation has been measured properly, particularly in the US. I am not convinced by the criticism of the data, but one has to be sure about what the inflation measure is actually measuring!

As we have said many times, even though headline inflation as measured by consumer price figures has been low in recent years, there has been inflation but in other areas. In particular, whilst headline inflation has been low, in recent years we have seen rapid asset price inflation in many countries, with rising prices of real estate and equities.

In many instances this has not been captured in the headline inflation measures.

Meanwhile, there is still intense global competition in internationally traded goods. The appreciation of the yuan is adding to concern that China's deflationary impact is disappearing.

Now asset prices are falling in many places. But instead we are seeing a rise in the relative prices of some food and energy. These are captured in the main inflation measures. Indeed, sometimes they are a large component. For instance, in China, food makes up about a third of the basket. This is leading to a focus again on so-called cost-push inflation, and whether rising costs of key factors can lead to overall inflation.

The last time there was a global focus on cost-push inflation was in the 1970s, when oil prices rose. How this feeds through in inflation depends, crucially, on two factors - the reaction of central banks and whether they accommodate this pick-up in prices or not - and whether the rise in costs feeds through into higher wages and into higher inflation expectations.

On that the jury is still out. In many poor countries, riots in reaction to higher food prices are often not a sign of rising inflation but more a reaction to an increase in prices that is not feeding through into higher wages, and that is both reducing the amount of food that people can buy and also squeezing the amount that they can spend on other items.

This deflationary impact of rising food prices is often overlooked. This explains the present challenge.

The writer is chief economist and group head of global research, Standard Chartered Bank, United Kingdom