FYI | Jul 25 2006
By Chris Shaw
Fear of inflation has driven central bank actions in recent months, with the US continuing to lift official interest rates as others such as Europe, Japan and Australia have followed suit and are expected to continue doing so, with most market commentators forecasting higher interest rates in coming months around the world.
But according to Morgan Stanley economist Andy Xie central banks have not done enough, as real interest rates are still closer to zero than to the 2% they were running at five years ago. This has allowed global inflation to push higher, Xie estimating it is now at a 10-year high as rising commodity prices, tight labour markets in developed economies and overheating in emerging economies have combined to put upward pressure on prices.
China, India and commodity markets are obvious examples of such overheating in Xie’s view, with further overheating likely unless central banks act swiftly to return policy to more appropriate levels.
Xie argues the problem is the big picture reason behind why inflation is rising is being missed, as rather than simply blaming a higher oil price the answer actually lies in the current easy monetary policy environment. While deflationary shocks such as the Japanese economy and the Asian Financial Crisis of the late 1990s helped keep inflation at bay, Xie points out these factors no longer apply and so the current rate of monetary policy tightening is no longer appropriate and must be speeded up.
This is particularly the case given the recent strengthening in domestic consumption in Japan suggests an inflationary rather than deflationary environment, as does rising export prices from China.
Xie suggests central banks may be lifting rates in response, but the inflation rate continues to increase even as interest rates are pushed higher, leaving two possible outcomes.
The first is central banks make a concerted attempt to lift global interest rates back to a neutral level, which requires in his estimation an increase of at least 2% and possibly more to fully counter the threat of inflation.
The other outcome is a significant sell-off in bond markets around the world, with as much as a 100 basis point increase in yields likely if bond markets globally accept the view inflation has now become a problem. Xie believes it is likely the bond markets will gradually come to this realisation as it becomes apparent the inflation problem won’t just disappear without policy action.
Xie’s conclusion is the global economy is adjusting from a period of below trend inflation and above trend growth to the opposite of above trend inflation and below trend growth, it’s just that most players in the market don’t seem to realise the transformation is underway.