FYI | May 18 2006
By Greg Peel
Yesterday FN Arena brought you a global inflation warning from respected Morgan Stanley economist Andy Xie (Be Warned, Inflation Is Coming) and although Xie’s warning is of a longer term nature, we have only last night witnessed the scope of inflation fears in the US as the Dow fell 214 points on the CPI numbers.
Andy Xie has long been a wet blanket when it comes to the global economy in the next few years. Many observers have previously shrugged off Xie’s fears, noting that higher commodity prices are offset by lower prices for products exported from emerging markets such as China. The global liquidity boom precipitated, in part, by rampant emerging economies has served to keep interest rates low.
That is beginning to change. 2002 saw sharp global disinflation following the tech crash, 9/11 and the rapid relocation of factories to China. The average inflation of the US, Europe, Japan and China fell from 3.2% to 1.1% sparking monetary easing from the US and Japan. Hence the liquidity boom.
Because of the liquidity boom, "Western" countries have experienced property booms and increases in consumer spending power. Developing economies have been provided with money to spend through the commodity boom, which it then invested elsewhere, particularly in US equity and credit assets.
The same measure of inflation has now doubled to 2.2% for the first quarter of 2006, although it still remains below trend. Xie notes many argue that this is simply headline inflation due to higher energy prices, and not the all-important core inflation. But Xie believes unless the commodity bubble bursts, core will catch up to headline, rather than headline falling to core.
The real scare on Wall Street last night was not the headline CPI measure, but the increased core measure.
Commodity inflation, and particularly that of the most consumed commodity in the world – oil – has not yet made its true mark on headline inflation, Xie believes. Companies have tried hard to absorb high oil costs in the hope it’s a temporary thing, and governments have maintained subsidies in order not to stymie economic growth. But oil has risen 250% since 2002 and coal and gas have doubled as well. This has not yet shown up in the global inflation numbers.
Wage inflation has also been kept low so far, but Xie suggests this is about to end, particularly in countries with large current account deficits (eg US, Australia). While wage inflation has been kept low due to effects of globalisation, where manufacturing has been passed off to developing economies and service industries have grown, this discrepancy must dissipate over time.
Xie makes special mention of Australia’s nagging inflation problems in what is otherwise a sluggish economy.
Xie also raises major concern that although often noted, tends to be overlooked in the scheme of things. That is China’s environmental problems. The world has benefited by shifting production to a country where not only are wages very low, but for the past few years environmental controls have been all but non-existent.
Effectively, the world has dumped its pollution on China. China’s pollution measure is now 12 times the world average. Sulphur dioxide emission is 22.5m tonnes compared to a carrying capacity of 12m. Two-fifths of seven major river basins are severely polluted, while 90% of city rivers are the same. 300 million rural residents have no access to purified water. One third of the country suffers from acid rain.
China has begun to act, and the result will be the forced closure of businesses that do not meet environmental standards. This will serve to reverse the disinflation of earlier years as China catches up to reality.
Xie believes global inflation will grind its way up from here, still tempered by labour substitution from West to East, but inflation will accelerate as this process reaches maturity. We have already noted workers in South American mines striking for higher pay as they watch company profits soar.
Bond assets will be the first to decline in this cycle, Xie notes (yields rise). Declining bonds will then bring down other assets and as the yield curve steepens and the commodity bubble will have to burst. Then the stock market will react.
Not everyone is a Xie supporter.