Inflation Is Still Not the ProblemBeginning in May, rumors of an inflation surge began spooking the markets.
But as the Bank Credit Analyst explained in a recently issued comprehensive report on inflation, these inflation fears are exaggerated.1
Some worry that the high costs of energy and raw materials will spark inflation as they did in the 1970s.
But BCA points out that the astounding increases in productivity and globalization have changed the rules of the game.
These new changes have dramatically reduced the impact of traditional inflationary pressures so that they simply can’t exert the same force they once did.
Even in China, the world’s most overheated economy, inflation has not been able to rear its head in this new global economic environment.
Once again, it is productivity and efficiency that continue to hold inflation in check, as wages and commodity prices rise.
This is because productivity gains cause unit labor costs to decline, even as hourly wages rise.
For example, headline inflation in China is just 1.2 percent.
More significantly, just as the Trends editors forecasted, China’s core price data indicates deflation.
Prices are falling for nearly everything in China: consumer goods, processed products, durable goods, and even recreation.
At the same time, China’s wages and commodity prices are on the upswing, which has led many to speculate that inflation and a downturn in profitability are just over the horizon.
But to the surprise of many pundits, inflation has not risen.
Once again, the reason is that we are in a new era of knowledge-driven productivity growth that dampens the impact of rising wages and commodity prices, and makes it much harder for inflation to take hold.
That’s why it’s crucial to make a clear distinction between wages, which are rising, and unit labor costs, which are falling.
While per capita income in Chinese urban centers is growing at 12 percent per year, the cost of labor measured per unit output is actually dropping sharply.
This is the new economic reality keeping inflation in check.
Higher wages aren’t inflationary if they’re leading to an even faster rate of growth at the output end of the economic engine.
When a company can produce more products with fewer people, it can both raise wages and lower prices to be more competitive, even while maintaining a healthy profit margin.
As a result, inflation has been low in China since 2001.
And it will remain low, as the 60 percent of the Chinese population that now lives in rural areas become integrated into the global economy, putting downward pressure on wages.
Everywhere, the global economy is playing by a new set of rules, and the evidence is all around us.
In China, under the old economic rules of the industrial age, increases in raw materials alone would have been enough to set off inflationary shock waves, as they did in the United States in the 1970s.
That’s because the global economy wasn’t nearly as interconnected, and prior to the info-tech boom that started in the ‘90s, productivity growth was much slower.
For North America and the EU, globalization and the IT-enabled productivity boom have led to an excess supply of imported retail products, and that has naturally led to steadily falling prices.
This has helped shape attitudes of consumers, who simply ignore items when prices go up and go looking for a better bargain.
That has meant that throughout the supply chain, from the manufacturer to the retail shelf, managers have had to get as much productivity out of the system as possible.
Thus intense competition influences consumer behavior, which fuels productivity growth, which causes unit labor costs to drop.
All of this means that inflation is kept in check.
Some non-core inflationary blips, are showing in the smaller Asian economies, such as Thailand, Indonesia, Malaysia, and the Philippines; but those are mostly due to the termination of fuel subsidies and do not reflect real inflationary pressures.
We expect this to reverse as oil prices decline.
India is one possible candidate for increased inflation, largely because of an imbalance between economic growth and infrastructure.
While the Indian economy has experienced very strong growth, that nation has lagged behind in upgrading its infrastructure, leading to rising prices.
But generally, Asia, where we would expect to see the first signs of global inflation, still continues to exert an overall deflationary influence on the global economy as the unit cost of labor falls, pushing export prices down with it.
The explosive expansion of trade in China, India, and smaller nations, such as Vietnam, has sparked fierce competition in the global export business, which has caused prices to trend down, not up.
Korea is another important marker for tracking inflation because of its strong currency.
A U.S. dollar is equal to about 960 Korean won, and that value represents a 26 percent rise since the middle of 2004.
Under the old industrial age rules, that should mean that Korea will be raising its prices on export goods to the U.S., but that hasn’t happened.
In fact, its semiconductor industry has recently seen a 25 percent per year drop in prices.
Prices of other Korean exports are falling, too, including heavy industrial machinery.
In short, the area of the world where we might expect to see inflation first, and expect it to be the worst, is experiencing little or none.
And supply-side forces should keep it that way by keeping the traditional pressures in check.
If Asia is stable with regard to inflation, global inflation has little chance of increasing.
Another traditional inflationary hot spot is Latin America.
Since World War II, we’ve seen unsound monetary policies and lagging productivity plunge those nations into hyperinflationary crises again and again.
But a look at Brazil and Mexico, the two largest economies in Latin America, shows that nothing of the kind is going on today.
Having adopted sound conservative policies and a drive toward productivity growth, those nations have low inflation.
At 3.2 percent, inflation in Mexico is approaching the rate in the U.S., and core inflation in that country is at a new historic low, despite booming demand for products and services.
As in China, wages are up, while export inflation is trending down.
Brazil, likewise, has been enjoying falling inflation figures for the last three years with wholesale prices falling for the past few months.
So where should we look for inflation if not in those most inflation-prone areas?
The central European economies are all showing low inflation or even mild deflation.
Inflation in the Czech Republic is 2.8 percent.
Hungry has a slightly higher level at 4 percent, but while commodities are high, producer prices are low.
Consumer prices in Poland are falling dramatically.
And with unit labor costs going steadily down, we can clearly see the same trend we have been discussing:
The new global economy and high productivity are keeping inflation at bay, even where we’d have expected to see it on the rise in earlier decades.
So in the very places where we might expect inflation to begin, it is either very subdued or non-existent.
Only in a few scattered spots where productivity is lagging, such as Argentina and Turkey, are we seeing any significant inflation.
Thus, the greatest damage to the economy is not likely to come from inflation, but from people who are so afraid of inflation that they overreact.
In light of this trend, we offer four forecasts for your consideration:
First, with inflation now a global rather than a local phenomenon, expect overall inflation to remain low for the foreseeable future, with pockets of deflation appearing here and there.
While economic growth should have pushed up core consumer inflation, it has not happened because of this trend.
With businesses unable to raise prices and facing higher commodity prices, they will simply be that much more driven to improve productivity to keep costs down.
Second, with trade in China, India, Vietnam, and other Asian nations growing at an astronomical pace, expect global prices to continue downward due to intense competition.
This will tend to keep inflation low, in part because nations with any significant inflation will be at a competitive disadvantage.
An imperative for being globally competitive will be keeping inflation in check.
Third, in light of the prospects of low inflation going forward, the Federal Reserve will stop raising rates this summer.
Looking at the same data as the Trends editors and BCA, the Fed’s FOMC ? Federal Open Market Committee ? will soon achieve its goal of an interest rate that grows the money supply just a little faster than the rate of economic growth.
Such a so-called neutral Fed Funds rate appears to be around 5.5 percent.
The Fed overreacted to excessive monetary growth in the late ‘90s by raising rates too high.
This time, it won’t make that mistake. Real growth of 3.5 percent will continue with inflation under 2 percent.
With low inflation expectations, bond yields will actually fall.2
Fourth, with the consumer price index remaining low and bond yields expected to fall, watch for the bull market in stocks to develop momentum.
References List :
1. Bank Credit Analyst, June 6, 2006, “Are Inflation Fears Justified?” ⓒ Copyright 2006 by BCA Publications Limited. All rights reserved.
2. The Wall Street Journal, June 7, 2006, “Economic Rehab,” by Brian S. Wesbury. ⓒ Copyright 2006 by Dow Jones and Company. All rights reserved.
