From the July-August 2008 issue of Treasury & Risk magazine

Shock Treatment for Global Inflation

Inflation is accelerating nearly everywhere, but most dramatically in the commodity-based economies. This has raised the hackles of world central bankers, who must now figure out how much they will need to tighten. However, the extent to which central bankers must raise rates will depend heavily upon whether the inflation we are seeing is more attributable to a relative or a cyclical shift in price levels. Relative price shifts tend to be more self-correcting and, hence, require less effort on the part of central banks to control.

For much of the developed world, the surge in commodity prices represents more of a relative than cyclical rise in price levels. Increase in the costs of oil and food, in particular, are crimping consumer budgets and causing demand destruction elsewhere in the economy. This, in turn, is bringing down the rate of inflation outside of the food and energy sectors. The reaction to surging oil prices in the U.S. provides a good example. Increases in prices at the pump have cut into non-oil spending, and forced retailers to mark down the prices of other goods. Apparel has gotten particularly cheap in recent weeks as many large retailers moved their July clearance sales into June to clear unwanted inventories. This is to say nothing of the drag created by falling home values, which has yet to show up in the consumer price index.

Prospects for inflation across the developing economies are more worrisome, especially among the commodity-driven economies of Latin America and the Middle East. We are also seeing a surge in inflation across much of emerging Asia. Those gains, however, are due more to a relative rise in food prices than to overheating. Indeed, economists in China argue the move by authorities to lift oil subsidies will only exacerbate the demand destruction being created by surging food prices. This is to say nothing of the disinflation that is being caused by accelerating productivity growth and excess supply of cheap labor migrating from the rural regions.

On net, we should expect to see significantly more tightening by the central banks of developing economies than those of the developed world. The Federal Reserve and the European Central Bank (ECB), in particular, are likely to raise rates significantly less than many market participants expect. Indeed, Ben Bernanke has recently shifted the Fed to more of a wait-and-see-stance on tightening, while many inside of the ECB feel that Jean-Claude Trichet moved too quickly to tighten, and expect that he will reverse course and ease once conditions in Europe weaken.

Moreover, the tightening in policy across the developed world is expected to remain extremely uneven. The more credible central banks of Latin America -- namely, Brazil, Chile, Mexico, and Peru -- will tighten in the second half and into 2009 to cool growth in those economies. The exceptions are Argentina and Venezuela, which may be forced to devalue their currencies and restructure their debt to deal with their inflation woes. All totaled, short-term interest rates are expected to drift up, and the yield curve is expected to widen over the next year. The magnitude of those shifts, however, could be much less than most market participants are expecting. The result could be significantly easier credit, better corporate profits and more bullish overall market conditions among developed nations. There will be greater extremes among the winners and losers among the developing economies, with some experiencing significantly more inflation and greater financial consequences than others.

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