GLOBAL INFLATION

LECTURE FIVE: AUGUST 2011

DEFLATION NOT INFLATION
Until the last few months it had
become fashionable to argue that
the main risk facing the global
economy is no longer that of
inflation, but of deflation a lengthy
recession, perhaps even a
depression.
Food and fuel prices
But since the start of 2011
concerns about inflation have
returned mainly reflecting:
The surge in oil prices, and
Sharply higher food prices
CURRENT FORECASTS

The most recent IMF forecast

(June 2011) predicts inflation in
advanced economies rising
from.1.6% in 2010 to 2.6% in 2011
before slowing to 1.7% in 2012.
For emerging markets it is 6.9% in
2011 slowing to 5.6% next year.
Medium term

But over the medium-term there are

many serious economists who fear
that the current response
especially massive govt spending,
low interest rates and quantitative
easing will translate into high
inflation.
THE HISTORY OF
INFLATION
RECENT PHENOMENON
Until 1914, prices were relatively
stable over the long run, with
periods of inflation often war-
related followed by periods of
deflation.
This all changed after World War II,
since when prices have risen very
substantially.
THREE EPISODES

Since the 1960s, the world economy

has experienced three episodes of very
high inflation, all of them associated
with oil price spikes:
1973-74

1979-80, and

1989-90
NOT JUST OIL

Although oil prices played a key

role in all 3 episodes other factors
were at work:
1. Changes in the exchange rate
regime
2. Supplyside shocks especially fuel
prices and
3. Changing macroeconomic policies
HINDSIGHT

With hindsight we know that while

steep rises in commodity prices
especially oil triggered high inflation
in the 1970s and 80s, the real
problem was the economic policy
response to these so-called supply
shocks.
OIL PRICES

Between 1999 and their peak in

July 2008,oil prices rose
dramatically from $12 a barrel to
$147 a barrel.
Despite this, inflation rose from only
1.4% in industrial countries in 1999
to 3.4% in 2008 and fell to just
0.1% in 2009.
 AVERAGE INFLATION

Years Industrialized Developing

(% p.a.)
1963-1972 4.2 n.a.
1971-1980 8.7 20.5
1981-1990 5.6 39.0
1991-2000 2.5 23.6
2001-2009 1.9 6.9
AVERAGE INFLATION
 1960s

Policymakers have learned over time.

In the 1960s, inflation began to
accelerate, though only to modest
levels, partly because of expansionary
fiscal and monetary policies, and
in the late 1960s and early 70s, due to
the US war in Vietnam.
 OIL SHOCK
When the first oil price shock hit in
1973/74, industrial countries were
around the peak of their business cycle
expansions.
Prices spiked in the mid-late 1970s and
thereafter, as monetary policies were
tightened, GDP growth was halted and
the world went into recession.
 DIFFERENT RESPONSES
The impact of inflation differed
depending on policies.
In the US and some European
countries, monetary and fiscal policies
were eased and, as a result, inflation
remained high.
 But in Germany and Switzerland
faced with the same oil shock
inflation was kept under control by
tight domestic policies.
In the US inflation got as high as
12%, but in France it was 15%, the
UK and Italy 25% and Japan 23%.
 RECESSION
But in Germany inflation never
exceeded 6% while inflation in
Switzerland was even lower.
After the first shock, governments
everywhere tightened fiscal and
monetary policy, which led to recession,
and inflation slowed markedly.
 SECOND SHOCK
There was a second oil price shock in
1979/80 associated with the Iranian
revolution.
The US was the only country in which the
inflation peak after the second shock was
greater than in 1974 and inflation moved
into double-digits.
 HEAVY COST

But at a heavy cost with GDP falling

and unemployment reaching 11%.
Recessions also proved necessary to
tackle inflation in many European
countries, though not in Germany and
Japan.
WAGES

The response of wages to inflation

shocks is crucial.
In Japan, for instance, real wages
were highly flexible and fell so that
employment was maintained.
But elsewhere, such as the US and
the EU, real wages were much less
flexible and employment fell sharply.
 TWO POLICY LESSONS

Two policy lessons were learned from

these first two oil price shocks:
1. It was important NOT to
accommodate the shocks by
increasing money supply, because
that led to inflation and inflationary
expectations that took years to
dissipate.
MEDIUM-TERM OUTLOOK
2. Flexible labour markets and
especially flexible real wages made it
easier to absorb these shocks without
a major decline in output and
employment.
Following these two episodes,
governments adopted medium-term
strategies that had three main
components.
THREE COMPONENTS

a) Stable monetary expansion in line

with real GDP growth
b) Fiscal consolidation to curb
government credit creation, and
c) Structural reforms of the product
and labour markets
SUCCESSFUL STRATEGY
That world inflation has remained low
despite the recent spike in commodity,
(especially oil) prices, shows that this
strategy is working.
Admittedly, there was another short
lived episode in 1990, associated with
the invasion of Kuwait by Iraq and the
subsequent oil shock
And again with the cost of German
Unification in the early 1990s.
 PRE-EMPTIVE STRIKE

The difference in the 1990s was that

governments adopted a pre-emptive
strike strategy.
Monetary and sometimes fiscal
policies were tightened before inflation
became a serious problem.
As a result inflation has since fallen to
40-year lows.
 EXCHANGE RATES
Exchange rate policy played a critical role.
Flexible exchange rates meant that a
government could use monetary policy to
expand output and demand in the
domestic economy.
The strain would then be taken by the
exchange rate which would have to
depreciate to adjust the BOP
 FIXED RATES ARE BETTER

An IMF study of 135 countries found

that inflation was lower in countries
with pegged or fixed exchange rates
than in those with flexible rates of
exchange.
Countries that allowed their exchange
rates to float
Or that adjusted them frequently,
experienced much higher inflation.
LESSON

The lesson as we have learned in

Zimbabwe is that fixed rates cannot
be sustained and must be adjusted.
There are serious inflationary
consequences if macroeconomic
policies overall are unsound as was
the case here.
POLICY REGIME
This explains why in a world of
mostly flexible exchange rates that
we have today
It is possible to still have very low
rates of inflation
The explanation is NOT the
exchange rate regime, but the overall
policy environment.
 FINANCIAL INTEGRATION
Financial globalisation has been decisive
too because greater integration has
enhanced the transmission of economic
shocks across national borders.
With greater capital mobility, interest rates,
output and inflation are increasingly
influenced by global developments in the
demand and supply of capital.
FINANCIAL DISCIPLINE
Increased capital market and
financial integration imposed greater
discipline on the central banks and
governments of different countries,
forcing them to abide by the rules of
the game.
This has had the positive effect of
slowing inflation globally.
COMPETITION
There is no doubt too that trade
liberalisation and greater global
competition have reduced inflation.
Intense competition translates into some
price cutting, but more importantly to
Productivity growth, which curbs
inflation
And the exploitation of scale economies
leading to lower unit costs and inflation.
TRADE BARRIERS

In contrast, high trade barriers and

Import controls
Protect inefficient monopolies and
cartels
Shelter high-cost, low productivity,
uncompetitive firms that contribute
to higher costs and inflation.
IS INFLATION DEAD?
Inflation since 1997
LIQUIDITY

Global money supply or global

liquidity has grown faster in the last
few years than at any time since the
great inflation of the mid-1970s.
Some analysts think this portends
higher inflation in 2011/12
But as yet there are no signs of this.
RESURGENCE

The graph shows a marked

acceleration in inflation in 2008 to
3.4% in industrial countries the
highest since 1991.
Developing country inflation was
9.2% - the highest for 10 years.
SLOWDOWN IN 2009

But when the recession struck

inflation slowed in 2009, falling
virtually to zero (0.1%) in advanced
countries and 5.3% in emerging
markets.
Industrial Countries
In industrial countries, the
combination of slowing demand,
sliding output and sharply reduced
commodity prices translated into
greater price stability.
Spare capacity in industry
restrained price rises as did the
weakness of consumer demand.
GLOBAL MONEY SUPPLY
GROWTH
GLOBALISATION AGAIN
Many believe that inflation has not
taken off because the global economy
is more open, more competitive and
more flexible.
Better economic policies and
management are ensuring that
inflation remains low.
THREE ISSUES
THREE QUESTIONS

Looking at the slide for the last

decade, it is easy to believe that the
inflation dragon is dead.

Three concerns are paramount in

2011:

1. Do we measure inflation accurately?

2. Will the eventual return to
higher oil and commodity prices,
as in recent months mean faster
inflation? and
QUESTIONS

3. Because of the global recession

and weakness in financial markets,
have central banks already gone
too far towards reflation thereby
rekindling inflation in a few years
time?
MEASUREMENT

The first question is perhaps the most

telling.
Economists argue that consumer
price inflation indices are just too
narrow and do not capture asset
prices, like equities and houses.
US inflation was just over 2% in 2004,
but housing prices rose over 13%.
 HOUSE PRICES
HSBC Bank has built its own index in
which house prices are weighted at 30%
of the total.
If this is included, then US inflation is
nearer 5.5% than 2% the highest since
1982.
This model applies to most countries
around the world where housing prices
rose steeply until 2008.
WHY AND HOW ASSET
PRICES MATTER FOR THE
GLOBAL ECONOMY
CONTRASTS
A feature of recent global economic
trends is the coincidence of large
asset price booms and busts with the
ongoing slowdown in consumer price
inflation.
This has given rise to some crucial
policy issues, as well as
Concerns that asset price movements
could destabilise the world economy
 FOUR QUESTIONS
Four crucial issues stand out:
1. What drives asset prices?
2. How do changes in asset prices affect
the economy?
3. Do large swings in asset prices pose a
threat to macroeconomic stability?
AND
4. If so, how should policymakers
respond?
WHAT DRIVES EQUITY
PRICES?
Analysts use price-equity ratios to
determine the fair value of a
stock.
Over the long haul in the US
market, the earnings yield
(inverse of the PE ratio) has
closely tracked the real rate of
return on shares.
 A PE ratio of 15, which is the
equivalent roughly of an earnings
yield of 7%, was the average for the
US S&P index in the second half of
the 20th century.
In fact, that is also the average REAL
rate of return on US stocks since the
end of WWII in 1945.
ACCURATE PREDICTOR
By 1999 just before stock prices
crashed in early 2000 the PE ratio
was double that at 32.
This implied an earnings yield and real
rate of return of only 3.1% less than
half the longrun average.
This implied rightly as it subsequently
turned out that shares were
substantially overvalued.
PRICES CRASH

In fact US share prices fell 46%

over the three years from their
peak (March 2000) to 2004.
While EU share prices fell some
55%.
Price-Earnings Ratios
PE ratios are driven by 3 factors:
1.The risk-free rate of interest on
govt bonds
2.The risk premium for equities,
and
3.Expectations of future growth
rates of corporate earnings.
PE RATIOS

This means that a rise or fall in

interest rates will push the PE ratio
up or down.
A rise in market risk will push the
PE up and vice versa.
Expectations of more rapid
earnings growth i.e. economic
boom will push the PE higher.
IMPLICATIONS

This means that:

i. Equity prices RISE as interest rates
fall
ii. As risk premia decline, and/or
iii. As earnings growth accelerates
At the end of 1999, just before the
crash, it appeared that:
a) Shares were overvalued
b) OR earnings growth was expected
to accelerate dramatically
c) OR that the risk premium had
fallen sharply
OVERVALUED SHARES
We know now that the above analysis
was right.
Equity markets all over the world fell
dramatically.
While PE ratios declined sharply,
though they stayed well above their
longrun average.
This led many analysts to predict that
there were more declines to come.
REALITY

In fact, while equities fell from 2000 to

early 2003, there were other factors at
play, apart from overvaluation.
The most notable of these were:
The terror attacks of 9/11 in 2001 and
The slowdown in the global economy
and therefore in the growth of
corporate earnings.
GLOBAL EQUITY PRICE INDEX
 REBOUND
Markets subsequently recovered and
share prices doubled between 2002
and 2007.
In EMs PE ratios rose from 12 in 2004
to a peak of 17.6 at the end of 2007,
before halving in 2008 and then
recovering to regain their record levels
of 21 in late 2009 and early 2010.
PE RATIOS (Ems)
MARKETS SLUMP
They have since fallen sharply from
21 to 14.6 at the end of 2010, while
US share prices fell 38% during
2008, while in China they declined
70%, Japan 44%, the Euro area
44%, Russia 66%, India 52% and
South Africa 23%.
None of the worlds 50 main stock
markets made gains during 2008.
2011
But in 2009/10 all that changed and
the latest figures for 2011 (August)
show US prices up 59% since the
end of 2008.
But China is only 1.5% over the
last year and industrial countries as
a whole up 3% since August 2010.
PROPERTY

Property prices are driven by real

incomes (with a lag) and
By real interest rates
As incomes rise and real rates fall
so property prices increase
Property prices are largely demand
determined, because supply
increases only slowly
RECENT TRENDS
In the last few years, there has been a
global boom in property prices that is
partly but not completely
explained by the three factors
mentioned
Lower real interest rates
Rising incomes, and
Sluggish supply growth
SHAKE OUT

Since 2007, however, there has

been a shake-out that has taken
two forms:
In some markets especially the
US housing prices have fallen
steeply
In many others, the growth rate of
home prices has slowed
dramatically.
TRANSMISSION MECHANISMS
Equity prices appear to be a leading
indicator of GDP growth.
A rise in REAL equity prices is a
precursor of faster and stronger GDP
growth.
In housing, it seems to be the output
gap between actual GDP and
theoretical or potential GDP that is the
main determinant of prices.
CONSUMPTION

Asset price increases lead to higher

consumption because owners of
shares and property feel richer and
(often) borrow and spend more.
Similarly, an asset price crash leads
to reduced consumption spending,
falling output and employment.
 MAGNITUDE
US evidence suggests that a $1
increase in equity market prices leads
to a 5c (one 20th) increase in
consumption spending.
The impact is much less in the EU due
to lower stock market ownership rates.
But property capital gains have a strong
impact on consumer spending in
Europe.
 PROPERTY GAINS

Higher house prices may have a direct

impact on consumption spending and
also
An indirect impact on borrowing and
property investment as owners raise a
second mortgage on their homes for
consumption spending OR
Perhaps to buy another property.
 INVESTMENT
The main impact on corporate investment
is via Tobins q factor.
The Tobin q measures the ratio of market
valuation of capital (shares) to the cost of
acquiring new capital.
 So if share prices rise, this
LOWERS the cost of acquiring new
capital relative to existing capital.
Firms therefore invest more as q
goes up.
Again this effect is greater in the
US/UK economies than elsewhere.
LESS IMPORTANT IN THE EU

This is due to fewer mergers and

acquisitions in the EU (until recently)
The fact that employees have a bigger
say in investment decisions,
especially in Germany, and
Higher gearing ratios in Europe.
 PROPERTY BOOSTS
INVESTMENT IN EU
But rising property prices have a
stronger positive impact on investment
in the EU and Japan than in the US/UK
In part this reflects the more widespread
use of property collateral against loans,
and
BANKS
The greater role of banks in
corporate financing than in the
US/UK
In the last 20 years, the financial
sectors share of GDP has grown
rapidly in many developing as well
as rich countries.
 DEREGULATION
As the financial sector has been
deregulated so competition has
intensified and banks and FIs have
increasingly gone into non-traditional
lines of business, especially asset
trading and mortgage finance.
 INCREASED EXPOSURE

Specifically, bank exposure to property

lending increased dramatically, doubling
in Japan and the UK and rising 50% in
the US.

As a result, swings in asset prices have

impacted directly on bank balance
sheets.
.
REPETITION
When asset prices crashed as in the
UK in 1989/90 and the US and
elsewhere in 2000 the banks non-
performing loan ratios rose steeply.
This has happened again very
dramatically in the mortgage lending
markets in the US, and to a much
lesser degree (so far at least) in Britain.
BANK CAPITALIZATION

On the upside, when asset prices

rise, so does the value of bank
balance sheets.
The result is that banks lend more
and a credit boom occurs that may
and often does become highly
inflationary.
 LENGTHY BOOMS
These swings in asset values underscore
the need for a well-capitalised and well-
supervised banking system to avoid bank
collapses.
Lengthy business cycle upswings contain
the seeds of their own destruction.
 Periods of equity and property price
booms, LOWER the real cost of
capital below its fundamental
level.
This due to expectational and
Tobin q effects leads to
overinvestment
 JAPAN

This is precisely what happened in Japan

in the early 1990s and 20 years later the
problem is still holding back Japanese
growth.
IS DEFLATION A PROBLEM?
 There are real worries that
deflation not inflation will
become a problem in 2011. and
beyond.
Deflation is associated with falling
output, rising unemployment and,
of course, falling prices.
SELF FULFILLING

It is a problem because it reflects a

situation of inadequate demand
It is self-fulfilling to the extent that
once consumers see prices falling,
they defer spending waiting for
prices to fall which they do.
GAMBLE

To avert this, governments are

gambling with inflation by
increasing spending, cutting taxes
and lowering interest rates.
The hope is that this will counter
the risk of deflation without re-
igniting inflation.
COMMODITY PRICES
Certainly, lower oil and food
prices have helped to prevent a
resurgence of inflation.
Commodity prices fell 30% in
2008, with food prices down 18%
and metals 49%
Oil prices halved during the year.
REBOUND
But in the last year commodity
prices have recouped their lost
ground.
Non-fuel prices are 17% above their
mid-2008 peak while oil prices that
fell 53% in 2008/9 are now just 20%
below their record high of July 2008.
COMMODITY PRICES
FACTORS CURBING INFLATION

In addition, a number of other

factors will help to prevent the
return of high inflation, including:
(i) Intense global competition
leading to cost and price cutting
CURBS - 2

(ii) Lower interest rates, which have

encouraged and facilitated
investment and helped spur
productivity growth.
(iii) Reduced government budget
deficits, resulting in less public
sector borrowing and slower
rates of monetary expansion.
 CURBS - 3

(iv) The China effect- cost leadership

strategies by Chinese exporters, as
well as the undervalued Chinese
exchange rate, have led to low costs,
low prices and low wages in many
industries around the world with
which China is a serious competitor.
CURBS - 4

(v) Rapid technological progress

continues to contribute to high
rates of productivity growth, which,
combined with cost-cutting
pressures, are helping contain
inflation.
CURBS - 5

(vi) Ongoing trade reform

negotiations the Doha Round
would have meant reduced tariffs
and lower trade barriers but these
are now stalled if not permanently
deadlocked, suggesting that this
effect is unlikely to be important in
curbing inflation.
DIFFICULT BALANCE

But while all these influences will

curb inflation, they will
simultaneously contribute to
deflation.
This means that the global
economy faces two delicately-
balanced risks.
RISKS

1. The almost negligible- risk that

there will be a W-shaped double-
dip recession resulting in deflation.
2. The risk that governments will go
too far in throwing money at the
problem, resulting in with a time-
lag higher inflation in 2011 and
2012.
UNCERTAINTY
At this juncture, it seems clear that
the downturn is over - though there
is still a tiny risk of a W-shaped
recession, and
Inflation remains very subdued,
though inflation has accelerated
somewhat since the end of 2010.
MODEST PRICE RISES
So at this stage, the consensus is
that the deflation risk outweighs
that of inflation, especially in the
light of two recent events.
CHINA TIGHTENS UP
1. The first is that China has
tightened its monetary policy
because of fears of overheating in
its economy, and
2. The second is the debt crisis in
the EU.
DEFLATION MORE LIKELY
An EU debt crisis would make
deflation MORE likely than inflation.
However, even with Spain and Italy
now teetering on the brink,
policymakers seem confident that
they will prevent the world from
slipping into either deflation or
inflation.