Diverging Views on Inflation

Just as we pointed out yesterday that different markets had differing implicit forecasts of inflation, not surprisingly, so too do analysts.

What makes the outlook for inflation a legitimately a difficult call is not merely weighing the inflationary and deflationary factors, but also considering how the various actors might respond. The focus has been on what central banks might do, but an equally important question is to what extend can and will companies pass along increases in input prices.

A further consideration is that in the 1970s, cost push contributed to the acceleration of inflation as workers had some success in winning wage increases to mitigate the depreciation of the value of their paycheck. But labor has very little bargaining power in the US. With employee compensation the biggest line item for most US companies, corporations may be able to reduce end product/service price rises by keeping a lid on pay. But Japan has been down the path of squeezing workers in an overlevered economy. It can lead to greater export competitiveness (Japan has a robust export sector), but is lousy for the domestic economy.

The Financial Times offers two contrasting views today. The first is from George Magnus, the UBS strategist who popularized the term “Minsky moment”. He continues to be bearish, sees considerable deflation potential, and thinks rises in energy and food costs have led to an exaggerated perception of overall inflation rates.

The second is from Tim Bond, head of asset allocation at Barclays, who takes the inflation threat as imminent, and finds evidence that manufacturers intend to increase finished goods prices rather than take thinner margins. He also disagrees with Magnus on the question of whether demand from developing economies might slow later in the year and take some pressure off commodities prices

From Magnus:

The inflation risk is certainly not trivial, especially in emerging countries, but there are two major reasons why the new scares should not be taken at face value in advanced economies yet. Moreover, to the extent that food and energy prices are a problem, governments should respond soon for fear that central banks – duty bound to contain inflation expectations – end up making the financial crisis worse.

First, banking crises and rising inflation make for improbable bedfellows. As de-leveraging evolves, the risks to growth, employment and profits are much more likely to produce disinflation. Two processes have much further to go before the credit crisis stabilises: the re-capitalisation of lenders and the build-up of personal savings. Both processes are deflationary and tell us more about future inflation risks than today’s commodity prices, which are in large measure the legacy of the global boom that is fading into the past.

Second….In clothing, cars, communications, health (excluding the US), household goods and housing, price inflation is non-existent or weak. The problems are those goods and services directly affected by the surge in prices in energy, food and strategic metals. Thus, while headline inflation has risen to 3-4 per cent, core inflation has remained quite stable in the last two years, fluctuating around 2 per cent.

Moreover, there are few signs of troublesome inflation in labour compensation…Food and energy inflation is a problem, especially for poorer citizens….

Rising inflation in emerging markets is serious….Emerging markets will see more credit tightening in the coming year but this will not be effective until they allow their currencies to appreciate more significantly or revalue against the US dollar and euro.

As western growth stagnates and emerging economies’ growth slips back, commodity demand and supply factors will realign to produce a meaningful fall in prices.

Even so, for structural reasons, such declines may be short-lived. If we have not started to deal with the longer-term issues of resource constraints and global demand patterns by the time the economic upswing arrives in 2010 or so, we could have a more awkward inflation environment, aggravated in the west by the start of an age-related expansion in public spending and by higher wages reflecting ageing-related labour and skills shortages.

This window of inflation relief should not be wasted. Governments should think ahead and encourage capital spending in energy. They must abandon the folly of bio-fuel subsidies, free agricultural trade and promote farming technologies. They need to embrace an agenda that recognises high food and energy prices are here to stay.

Now to Tim Bond:

Despite a US flirtation with recession, global inflation has both accelerated and broadened over the past few months. Inflation is no longer confined to natural resource and energy prices….The most recent UK data showed both goods and services inflation accelerating sharply….

US import price inflation has quickened in all sectors, including consumer goods and capital goods, items that had previously been declining in price. Import prices from China and Asia, which deflated steadily in the decade to 2006, are now accelerating sharply. Even in continental Europe, where external inflationary pressures have been mitigated by a strong euro, non-oil, non-food raw material import prices are rising at an annual rate of 6.5 per cent.

In such an environment, it is unsurprising to find that businesses are more confident about their ability to increase prices. Despite reasonably severe domestic economic weakness, the US NFIB small business survey for April reported a sharp increase in the balance of respondents intending to increase their selling prices. Such readings have not been seen since 1981. Reminiscent of the 1970’s, business pricing has started to behave in an atypical, non-cyclical manner, as firms raise prices even under conditions of weak domestic demand.

Outside the industrialised economies, inflation is rising at an ever-brisker pace…. In general, wage and consumer inflation trends are much more closely correlated in developing economies than in the West…..

Unchecked wage-price spirals in developing economies offer no evidence that the demand push pressures on global resource prices might abate. The acceleration in developing economy wage costs, allied with an appreciation of the relevant currencies, creates a much less attractive relocation environment for companies in high cost, industrialised economies. Just as globalisation is now delivering a significant inflationary shock via the developing world’s impact on resource prices, so the associated wage trends are starting to lessen the competitive disinflationary pressures on mature economy labour markets.

The one bit of positive news in Bond’s reading is that advanced economy workers may face less competition from outsourcing. Note that wages do not have to become equal for the cost advantage to be derived from offshoring to be no longer worth the risk and bother.

Remember that wage rates aren’t the only factor in the calculation. Sending work overseas involves much greater administrative costs, which offsets the labor savings and reduces flexibility. For instance, an IBM document leaked to the Wall Street Journal discussed Big Blue’s plan to outsource some programming to China, where the labor cost was 25% of US programmers. However, experts noted that the cost savings were likely to be only 15 to 20%. That gives you an idea of the amount of additional administration involved. Admittedly, this was a few years ago, perhaps companies have become more efficient. Yet an April 2005 survey by Deloitte Consulting of 25 companies with revenue of over $50 billion found that these large international companies, presumably best able to avoid obvious pitfalls, found that “In the real world, outsourcing frequently fails to deliver on its promise.” Over 70% of the companies reported having a “significantly negative” experience. But as with second marriages, hope seems to trump experience.

In manufacturing, you have shipping and quality control costs to factor in (an attorney I know who does a lot of licensing deals with Chinese manufacturers says the reject rates regularly run over 50%). However, US companies have become habituated to telling shareholders that they will improve profits through outsourcing and they may continue inertially with an approach that is yielding diminishing returns with hidden costs, such as reduced operational control.