Australia | Jun 02 2008
By Greg Peel
It “seems” like inflation is incredibly high. While for Australians the weekly trip to the supermarket is enough to invoke this feeling alone, it is at the pump where the focus has suddenly been riveted. When we had to start paying $1.60/l for petrol last week, it was as if a penny had dropped. The household budget is in trouble, and will be more so if the oil price continues to push higher as is the current prediction. Inflation measures such as the TD Securities-Melbourne Institute gauge released this morning confirm the persistence of high inflation, even as indications of an economic slowing continue to emerge.
The risk for householders is that the RBA will have to raise the interest rate again, and that would be another knife in the side for the average household.
CommSec has been producing a weekly report on petrol prices in Australia for three years, and never have the economists experienced such interest in the report before now. Petrol has become the topic of every barbeque conversation, and dominates parliament. Petrol is the biggest single weekly purchase for most Australian households, notes CommSec, so such concern is understandable.
However, that purchase only represents on average 3% of the weekly budget. Back in the 1980s, we were outlaying 4.4%. Nevertheless the hot debate in parliament at present is over the government’s proposed national FuelWatch scheme. CommSec’s research, and the Western Australian experience, suggest such a scheme will make very little difference. Drivers have now learnt the routine of filling up on a Tuesday or Wednesday, when petrol can be up to 15c/l cheaper than on a Friday, notes CommSec. Who needs FuelWatch?
As for whether talk of continuing increases in fuel costs is justified, CommSec reiterates for the umpteenth time that the industrialisation of China is simply the pervasive factor that is not going to go away. “The world has never seen an event like the industrialisation of China”, the economists note. The obvious example to draw on is the similar growth experienced by Japan in the 1960-70s, but in Japan we were not talking about 1.3 billion people. The Chinese are getting wealthier, and thus drawing on more and more of the world’s resources, including oil.
The RBA has conceded that inflation will remain high for a sustained period of time. To that end the central bank may need to rethink its approach to, and measure of, inflation. Is the 2-3% comfort zone no longer realistic?
In the US inflation has also become an issue, and similarly Americans have had a wake up call now that petrol has hit US$4.00/gal. As this equates to about A$1.10/l, we can wonder what the Americans are worried about, although they are by far the biggest per capita consumers of petrol in the world. Spare a thought for the British, however, who pay something like double the US price.
However while Americans would agree with Australians that it “seems” like inflation is now incredibly high, US measures of inflation have been very benign indeed on a global comparison. This has sparked suggestions of data manipulation by the government (this has a long and confirmed history), or that the method of measuring inflation is misleading (the Clinton era inclusion of “equivalent rent” for homeowners has always been criticised, and as home values have fallen this factor has acted as a dampener), or that inflation has simply become a state of mind.
Credit Suisse economists in the US have offered one explanation for inflation “seeming” so high when it’s not (they do not buy the manipulation argument). They separated those items used in the measurement of the consumer price index into two categories – frequently purchased items and not frequently purchased items. The former category includes the likes of petrol, food, utilities, clothing, rent, pharmaceuticals and so forth. The latter includes so-called “durable” goods such as cars or fridges.
What CS found was that the inflation rate for frequently purchased items is running at 4.7% year-on-year as at April, while the equivalent rate for durable goods was only 2.2%. Were the economists to undertake a similar exercise in Australia the same sort of figures would no doubt emerge. Petrol has never been more expensive, but cars have never been cheaper. A consumer might buy petrol every week but a new car only once every few years. Yet both are included in every monthly CPI measure.
This has the effect of keeping inflation lower than the consumer’s anecdotal experience suggests. Another factor to consider is that central banks always prefer to focus on “core” and not “headline” inflation.
The justification for this is logical. Under normal circumstances prices for both petrol and food fluctuate from month to month and even week to week. Petrol prices go up and down on short term supply/demand issues, and food prices vary with seasonality and weather. In order to gauge the underlying trend of inflation, central banks leave out food and energy costs to arrive at the “core” reading. The theory is that food and energy prices will rise and fall, but always trend back to the core.
This is all well and good, but for one problem. For the theory to work there must be as many months where the headline inflation is below the core rate as there are when it is above. But in recent years nearly all monthly readings show headline inflation greater than the core. The simple explanation for this comes back to China in particular, and the developing world in general. There has been a secular step-jump in demand for food and energy, so how long can central banks go on pretending food and energy prices don’t matter? The US Federal Reserve is currently looking into this issue.
Another economic measure popular with economists is “expected inflation”. This is really just a survey of consumers and businesses as to whether they think inflation will persist or not. One might wonder why economists are at all interested in a mere layman’s opinion.
The reason is that actual inflation will often trend towards expected inflation, rather than the other way around. Central banks are most concerned with whether inflation becomes “anchored” or not. If there is, for example, a sudden oil shock – like Hurricane Katrina wrought perhaps – then consumers will suddenly be paying higher petrol prices. But they will be unlikely to believe those prices will persist in the longer term, given rigs and refineries will eventually come back on line. Businesses will not be quick to raise prices in the short term, but rather will wear short term margin compression so as not to lose customers. Workers will not feel they suddenly need higher wages tomorrow.
In this case inflation may jump, but inflation expectation may not. Thus economists can be comfortable in believing inflation will fall back to meet expectations. However, if the reason for short term inflation is something consumers believe to be more rooted – such as growing Chinese demand for oil – then it’s a different story. Inflation will be high and inflation expectations will remain high. Businesses will raise their prices and workers will begin to demand offsetting pay rises. That’s pretty much where we are now.
But consumers can also have confidence that the central bank will respond to high inflation by tightening monetary policy, and hence they may not expect high inflation to last for too long. Unfortunately for the RBA, it appears the tightening cycle is not yet over. The bank itself is concerned about persistent inflation into 2010, so it can hardly expect Australians to think otherwise. The RBA is also very concerned about wage claim increases as a result, as these lead to a classic inflation spiral.
With all the hysteria surrounding the oil price at present, it’s hard to see why any consumer across the globe would expect inflation to ease anytime soon. This is scary, as on the above discussion of expected inflation it means actual inflation has no chance to come down at all. But within the ranks of economists and financial analysts the big debate is how much of a US$130/bbl oil price is reflective of growing global demand, and how much is due to rampant speculation. It hasn’t helped that respected oil magnate T. Boone Pickens has called oil at US$150, or that Goldman Sachs happened to mention a worst-case scenario of US$200, or that the question of “peak oil” is firmly back in the spotlight.
There is little doubt speculation is playing its part, and increases in futures and commodity fund interest bears this out. Few disagree that the growth of developing world demand is the underlying influence that will keep fuel prices generally high for a long time yet – perhaps rooted in triple digits. Central bankers are not, however, envisaging the same sort of stagflation scenario persisting as was the case in the 1970s. Higher oil prices will reduce demand in the developed world, and economic growth across the developed world is slowing, led by the biggest economy of them all.
But it is not the developed world creating the inflation problem. The economists at US bank Wachovia note global demand for oil has grown from 78 million barrels per day in 2002 to 87mbpd in 2008. Basically all of that demand growth has come from the non-OECD economies. OECD economies have managed to keep oil consumption growth flat by increasing fuel efficiency. The developing world is simply getting richer, and demanding cars for the first time.
The question is whether or not this greater global demand means higher oil prices will lead to generally higher inflation levels. While oil is influential in the price of many goods, be they made from oil or transported using oil, Wachovia notes that inflation requires “general” increases in prices of everything across the board. A price rise in one element should not necessarily lead to generally increased inflation.
We then come back to core rates of inflation, which Wachovia notes have actually fallen across the globe from their levels of a year ago. A lot of the inflation problem has been due to the immediate need for the US Fed to address the credit crisis, and as such resultant rate cuts have weakened the US dollar and mathematically pushed up commodity prices. Canada and the UK have also cut cash rates.
But Europe has not moved its cash rate in response to the credit crisis, and nor has Japan. In Australia the cash rate has been steadily raised. By all accounts the Fed has also now stopped cutting its cash rate, suggesting it is time to focus on inflation now that financial markets have at least stabilised. Economists in the US are beginning to talk about a possible rate rise in August. In all OECD economies, whether rates have been cut or not, economic growth is slowing. The eventual effect of such slowing will be to bring down core rates of inflation.
The same will not be true in the developing world, where economic growth will remain at high levels. But Wachovia also notes that developing world central banks are unlikely to respond to increasing inflation by aggressively raising cash rates, lest they stall their economic juggernauts altogether. Developing world economies will thus continue to experience high levels of inflation. Part of this problem is brought about by artificial currency constraints. The world’s biggest oil producer – Saudi Arabia – has its currency pegged to the US dollar and will continue to do so. But what this has meant is that despite a booming economy the Saudis have had to cut their cash rate along with the Fed. Little wonder the inflation rate in Saudi Arabia has risen from 1% in 2002 to 8% today.
The International Monetary Fund predicts that OECD core inflation will fall from 2.6% to 2.2% over the course of this year. Non-OECD inflation will, on the other hand, rise from 6.3% to 7.3%.
But what this particular imbalance means is that the real value of non-OECD currencies will appreciate. China, for example, is happy to allow its pegged currency to steadily appreciate against the US dollar as a means of keeping control over rampant economic growth. This is good news, as it was undervalued currencies that got us into this mess in the first place.
Prior to the credit crunch the US was building up a significant current account deficit against the developing world, such that the US dollar was already weakening. The tech-wreck and 9/11 prompted the Fed to cut the cash rate dramatically, making cash extremely cheap and allowing Americans in particular to spend beyond their means. The Fed later tightened the cash rate in response to inflation brought about by emerging Chinese demand, but the current account imbalance kept growing. The credit crisis brought bout fresh interest rate cuts, and this time the Chinese economy had become a freight train which meant China had to allow its currency to appreciate.
The appreciation of the Chinese currency, and slowing of the US economy, have both contributed to the US current account turning around and beginning to contract. If this trend continues, the US dollar will have the opportunity to appreciate. What happens if the US dollar appreciates? Commodity prices come down.
So the bottom line is that developed world inflation should eventually begin to ease as the current trend of economic forces continues. It will not be a decade of double-digit inflation as experienced in the oil-embargoed world of the 1970s. It does not, however, mean that we won’t have to adjust to a somewhat different domain, even if it simply means we’ll all be driving electric cars in the future. The oil embargoes of the seventies were the catalyst to eventually make the Japanese small car more popular than a GM or Ford gas-guzzler. If we can now just get over our strange love affair with SUVs, then oil demand should eventually fall and oil prices likewise.