Saturday, October 17, 2015

Inflation: Think Global (In Chart)

A few observation on inflation from a global perspective

#1: Global inflation has been weak, but core has been steady. Here the global data points (like headline or core inflation) are calculated using the GDP weighted national measures of the top 20 countries in terms of GDP in current dollars (representing 79.9% of world GDP. Pareto!!).

The difference between the core measure and the headline is even more important as the wedge between them is currently driven mostly by a single factor - energy prices. The concept of inflation is an overall price rise. A change in a particular component is mostly a relative price change, not an overall price change. Central banks have little controls over production of individual goods and services. If there is a large relative price rise for doughnuts for some reason, a hike in policy rates most probably is not going to help it (unless this relative price rise permeates through the economy and finally in wage expectation through second round effect).

#2: The smack-down of inflation in commodity exporting countries is most prominent for the ones with fixed exchange rate regimes. With a few exceptions, most of the metal and energy exporters are not suffering any great dis-inflationary pressure in core measures otherwise.

#3: In terms of professional forecasts, inflation expectation remains steady, but the market based measures for the US are not so. 

#4: The consumer demand is weak. Especially if we measure in dollar terms. We have a scenario of low rates, a strong dollar, very weak commodity prices and weak global demand. Commodity prices respond a lot to investments expenditure globally. However, the consumption expenditure has been a relatively stable component of economies across countries and time historically. Since mid of last year the consumption expenditure globally in dollar term has been in a strong contraction phase, approx 6% from peak till Q2 2015. This is only matched by an approx 8% drop during the GFC. And this is not driven by US or China much, rather rest of the world, including Euro area and Japan. It is hard to say if this has bottomed out and we will see the savings from drop in energy prices being channelized to recover consumer demand. 

Nonetheless, the possibility of a wage driven inflationary pressure cannot be dismissed. The chart on the left shows scatter plot of job opening rate (JOLT), Employment Cost Index and PCE core inflation against headline unemployment rate on x-axis, since 1980. The starting points are marked in red and end points in green. As we see in case of job opening, there has been some significant hysterisis (unemployment rate higher, given the job opening, if we measure the slope from the earlier part of the curve). This may points to a case of structural problem in unemployment. That will put forth a case against a downward revision of Fed's unemployment target (NAIRU). On the other hand the wage inflation (here ECI) and broader inflation (PCE) still shows inverse relationship. The Phillips curve is still alive (esp. for wage inflation), although flatter in recent times. Given the fact that Fed action has always a lag before it affects the real economy, this will keep the case for a early hike on the table.

#5: And related to above point of global consumption, the global imbalance in excess savings seem to be heading towards a forced reduction. The left chart shows excess savings (or equivalently current account balance) in nominal dollar terms. As we can see the large CA deficit of US has historically been balanced by large surplus of Japan and lately China. The EM had a spike just after the late 90s Asian Crisis. But that is mostly negated now. The recent cause of concern (Euro Glut) was a large and ballooning surplus of Euro Area. With the fall in oil prices, the Petrodollar balance is now going the other way to counter it. These low commodity prices may play a crucial role in re-balancing the flow of trades and capital across the globe. ( it is evident from the chart that trade volume has come down significantly.) It is not clear to what extent this balancing act will help consumption and through what channel, but it is definitely better than exploding imbalances in the medium to long term.

Also since the financial crisis, after the very initial period, it has been mostly a battle fought by central bankers, with fiscal stimulus sitting mostly on the sideline. In fact the withdrawal of high fiscal stimulus just after the collapse might as well have countered central bank efforts. We are politically getting in a better position to consider and use fiscal stimulus than the height of European Crisis and talks of austerity. The global budget balance is in fact back to the pre-crisis average level. And if the economy is not, there is a good reason and scope for fiscal stimulus in coming years.

The key takeaways: Despite the weak global demands and large savings imbalance (which are related), there is a case that the commodity prices has done some corrections, and a persistent weak demand/ high global excess savings may not be realized. And we still have the upside of fiscal stimulus in case consumer demand needed a booster does. At a global level, most measures of core inflation, and non-market based inflation expectation remains robust. However, the market seems to be pricing a very pessimistic outlook for inflation globally. And also as mentioned earlier the inflation skew pricings are improving on the upside surprise.

Is this a case of peak (dis-)inflation worries and significant consolidation and upside from here. Hard to be sure, but I would say chances are good than they were before. Of course inflation can go either way from here, but in most scenarios they have a better chance of ending up higher than current levels. And a reasonable dollar weakness from here can tilt the balance in its favor further.

1) In case Fed is on time (which we will only know with the benefit of hind sight): long inflation upside and nominal rates sell-off with short dollar for cheapening.
2) In case Fed is delayed: long vol - a sharper rate of hike will catch many unsuspecting asset classes on the wrong foot.

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