The trap is sprung
On Wednesday the data for US inflation in January were published. The Consumer Price Index rose in January by 0.4% and the ‘core’ index, which strips out ‘volatile’ items such as food and energy, rose by 0.3%. In both cases, this was ‘more than expected’.
Let’s gloss quickly over the issue of ‘more than expected’, meaning that the analysts whose job it is to forecast these data had predicted 0.3% and 0.2%. Apart from the fact that forecasting monthly data is inherently very difficult, there is no valid reason for anyone to be surprised that inflation is rising – least of all the professional analysts. As noted in this column over recent months, there is virtually no country on earth, regardless of size, geographical location and economic structure, in which the last few CPIs have not beenhigher than expected. Would it be too much to ask for the professionals to adjust their expectations in line with reality?
In any event, the indisputable statistical and economic fact is that inflation – i.e. the rate of increase of goods and services generally – is rising. Even more indisputable is the fact that the rate of economic growth throughout the developed world is falling. No day passes without a government or a supra-national institution (such as the IMF) issuing an updated report-cum-forecast in which the forecast rate of growth in 2008 for a country or region, or the whole world, is reduced. The debate continues as to whether, and if so when, the developing world will ‘re-couple’ with the US and see its very high rates of growth reduced too; within this debate, the evidence is running in favour of re-coupling, meaning that China, India et al will also slow from their frenetic pace of recent years.
Higher inflation and lower growth is the worst possible combination for most people, especially for central bankers. In the case of the US, where growth is already barely positive (0.6% in the last quarter of 2007), the rise in inflation brings closer the prospect of the dreaded ‘stagflation’ disease – low or no growth and high inflation. This, in turn, means that the Federal Reserve Bank and its Chairman, Ben Bernanke, are effectively trapped.
Bernanke and his colleagues have made it crystal clear, via their words and actions in recent weeks, that they are now committed to giving primacy to the struggle to prevent or mitigate a recession in the US economy. The policy of sharp and rapid reductions in short term interest rates might also, in the best case, help recapitalise the stricken American banking system – as a similar policy did in the early 1990s, in the wake of the previous mortgage lending crisis, triggered by the collapse of the S&Ls. By implication, they have demoted the task of achieving price stability – defined as a rate of increase in core CPI of 2% per annum – to a poor second.
It may be that the Fed thought – or even still thinks – that the weak economy will do the job of quashing inflationary pressures, thereby justifying its new order of priorities. If so, it looks like the Fed – and with it, most of the mainstream economic community – is wrong.
One reason for this is the Fed’s own policy. The massive surge in the price of oil this week, to over $100 a barrel, left analysts searching for a reason – what Antoine Halff, an expat Israeli energy expert in New York called ‘a rally in search of a cause’. The factors within the oil sector itself were insufficient justification for a move of this size – but the justification may well lie outside the oil industry. The rise in inflation and the ongoing erosion in confidence in the dollar, the Fed and the entire US financial system, which is being stoked by Bernanke’s policy of massive monetary reflation, is driving investors from paper to real assets.
Oil is a slimy, smelly, real asset. So is clean, shiny, attractive gold – whose price also surged afresh this week. As did copper and most other commodities, almost all of which are dollar-denominated. The grains complex has run amok, this time due to harsh weather in China creating shortages of most agricultural products. Equities, too, are real assets – most shares still represent actual ‘things’, not just paper wealth, which may explain another feature currently puzzling the analysts, namely why the continued deterioration of the debt markets has not fed through to equities. The markets seem to believe that inflation is a problem that is here to stay.