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All of
a sudden, the world’s central bankers are talking about
inflation expectations.
European Central Bank (ECB) president Jean-Claude
Trichet started the process by saying he was “strongly
determined” to anchor inflation expectations. US Federal
Reserve Chairman Ben Bernanke recently said his central
bank would “strongly resist” any erosion in price
expectations. This led markets to contemplate the
possibility of rising interest rates.
So
what are inflation expectations doing? In the
Organization for Economic Cooperation and Development
(OECD), companies’ inflation expectations are stable.
Companies do not believe they can raise inflation in an
environment of weakening growth and reduced consumer
credit.
For
consumers in the OECD, there is a different story. Here,
price expectations have shot upward. In the United
States, consumers are expecting inflation to increase
over 7 percent in the next 12 months. Inflation in
America has not been over 7 percent since 1982.
Inflation expectations of European consumers are up
significantly, at levels not seen since the introduction
of the Euro notes and coins.
So, is
there a problem? UBS research suggests that companies
are generally fairly good at predicting levels of core
inflation. Corporate management is good at predicting
future pricing power. Stable corporate price
expectations suggest that central banks need not be
concerned.and that core consumer price index (CPI)
inflation will be contained.
Consumers’ price expectations, in contrast, are
generally not terribly accurate. In fact, consumers are
generally very bad at predicting inflation. Future
expectations are strongly influenced by current
perceptions of inflation.
Current inflation perceptions, in turn, are influenced
by the price of things bought on a daily basis—food,
petrol, newspapers. While important items, these are
only a part of the overall CPI basket, hence consumers’
inaccuracy in predicting inflation. If consumers are bad
at predicting inflation, and consumer expectations are
the main area of increasing inflation expectations, why
are central banks sounding worried?
The
answer lies in what economists call “second-round
effects.” Consumers may not be accurate in their price
expectations, but those expectations might influence the
wage increases they demand from their employers. Those
wage increases, in turn, could influence broad price
levels (labor costs are the most important part of
inflation).
Central banks are looking for continued wage restraint
in the face of higher food and energy prices. If there
is no wage restraint, then the risk is of a return to
the 1970s—a wage-price spiral. If there is wage
restraint, then inflation is no threat. Indeed, if
inflation expectations are not matched by wage growth,
there is a risk consumers will believe their standard of
living is being damaged. That causes consumer confidence
to fall—which might then weaken the economy.
The
cost of labor in the United States and in Europe does
not suggest that wage restraint need be a problem.
Inflation expectations for consumers are higher, but
those consumers do not seem to be able to do much about
it when it comes to wage demand. In the first quarter,
US unit labor cost at just 0.7 percent compared with Q1
2007. In the Euro area, negotiated wage settlements
achieved a zero-percent increase year-on-year at the end
of last year.
In the
Philippines, data on inflation expectations on the part
of consumers and businesses are hard to come by.
However, just like the ECB and the Fed, the Bangko
Sentral ng Pilipinas is now talking about the need to
anchor inflation expectations.
The
wage board minimum-wage increases earlier this year,
brought forward at political behest, are a policy
reaction to the same phenomenon—that of a rising popular
appreciation of inflation. It seems likely that
private-sector firms also have to face demands for
higher wages.
In
all, rising inflation expectations in the Philippines,
as elsewhere in Asia, are helping fuel second-round
inflation effects.
UBS
believes inflation will remain controlled in the OECD
economies, but that it is a bigger problem in emerging
markets. For all the talk of concern about OECD
inflation expectations and wages, there is no evidence
that this is a problem yet. Raising interest rates in
emerging markets seems a sensible strategy. To do so in
either Europe or the United States would be a policy
error. Sadly, it is an error European policymakers seem
likely to commit soon.
Paul
Donovan is the managing director and deputy head of
global economics of Zurich-headquartered UBS. He is
responsible for formulating and presenting the UBS
Investment Research global economic view, drawing on the
bank’s worldwide resources. Donovan took up philosophy,
politics and economics at Oxford University. He holds an
MSc in financial economics from the University of
London. In the Philippines, his column will appear
exclusively once a month in the BusinessMirror.
You
cannot escape it, except maybe if you go see a movie.
During breakfast, lunch, merienda (snack) and dinner,
the cost of fuel, the peso, the stock market or the
economy dominates the conversation.
The
gloom and doom is becoming so pervasive, you can almost
cut it with a knife. Gasoline prices increase weekly.
The peso’s erratic depreciation is giving both importers
and exporters headaches. Stock-market analysts are now
saying they cannot find a bottom to falling share
prices. It seems that the international experts are
lowering Philippine growth expectations with every
review.
So
what is the solution?
Like I
said, go to a movie so you will not have to hear all
this. The world is not coming to end.
As I
wrote recently, there is a looming disaster if the
Philippine trade deficit and inflation spin out of
control. Of course, the policymakers have reached the
height of their capability; they have done very little.
However, the center of the perfect economic storm is the
high price of crude oil combined with the global
weakness in the value of the US dollar. The oil and
dollar are completely intertwined, with one another and
one aggravates the other.
I am
not confident the government will do much to handle the
trade-deficit/inflation problem. However, I do think
time is on the side of the country. Before the disaster
occurs, the price of crude oil and, therefore, other
commodities will fall like a rock.
Although you cannot find a single word of encouragement
about the Philippine Stock Exchange (PSE), that should
not worry you personally too much since I know you
unloaded all your big-cap issues some time ago, right?
The
PSE composite index is targeting 2,400 to 2,350 as the
first support level. If that area goes, then 2,150 is on
the horizon. I know that seems like a major catastrophe.
Let me give you the best-case scenario that is not off
the possibility charts.
Just a
few points below where we are now is the 2,350 area.
Granted that prices must stop going down before they can
turn up, foreign selling and heavy downward volume is
starting to dry up. Further, the very long-term
(multiyear) technical indicators are just beginning to
give a preliminary and weak sell signal. The last signal
given by these indicators was a buy sign in mid-2003.
If a
sell signal is triggered, then we are looking at a
several-year down market to at least the 1,200 level.
From an economic standpoint, that scenario would require
a major financial upheaval/meltdown on a global scale
that would make your stock-market portfolio the last
thing on your mind, believe me.
The
weak US dollar is the major factor in the high price of
oil. This is the first time in my 30-plus years in the
financial markets that I have observed the US Federal
Reserve sitting on its hands, doing nothing to
strengthen the dollar. The Fed is the elephant in the
dining room that can do whatever it wants with regard to
the dollar. The Fed can put the price of the dollar at
any level against any currency at any time. Yet, for
more than a year, the Fed has been comatose. This has
never happened before, so that means the US wants a
cheap dollar. Why?
I
wrote in March that it could be that the US was waging
an economic war with China, since China is suffering
with the weak dollar. I think that is still true, but
now I believe it goes much farther than that.
The
economic pain caused by the weak dollar is being felt in
every corner of the globe, directly through decreased
trade to the US, and indirectly through high-priced oil.
Intervention by the Fed to strengthen the dollar could
take at least $30 to $40 off the price of oil in a few
days. New rules on oil-futures speculation could drop
oil by another $30.
Isn’t
it in the best interest of the US economy for oil to go
lower? Of course. But if oil dropped fast and hard,
there would be even a larger destruction of the global
financial institutions than what happened with the
subprime crisis.
The
multinational financial firms are cleaning up their
balance sheets as fast as possible. Instead of
protecting their share prices, they are writing down
losses very rapidly, probably at the insistence of the
Fed. This is very unusual.
Banks
and other financial institutions in every country have
massive buying positions in oil and huge selling
positions in the dollar, either directly or from their
clients. Were the Fed to pull the trigger now, the
effect would be widespread bank failures.
However, when the Fed feels global financial
institutions can weather the storm, it will intervene
with a vengeance and drive oil down and the dollar
higher.
Note
this also. From anncoulter.com: “As election predictors
go, the Dow Jones has been remarkably accurate. If the
Dow goes up from the end of July to the end of October,
the incumbent president or vice president wins; if it
goes down, the incumbent loses. It has been wrong only
four times since the Dow was created in 1896.”
My
feeling is that the banks will be ready by September and
the Fed will move, pushing stocks prices higher and the
US economy with it, creating conditions that will move
John McCain into the White House as an added benefit to
lower oil prices.
E-mail
comments to mangun@email.com. |
