June 2008

Inflation is back after a lengthy period of relative containment. In many industries, rising commodity/raw material prices are increasing production costs.

Depending on a number of factors, such as the stage an industry is at within its own or the general business cycle, producers can either pass on higher input costs to end-users (retaining profit margins) or absorb them (reducing margins to maintain market share). As the process of passing on higher costs takes time to infiltrate the overall economy, consumer-price inflation tends to lag producer-price inflation.

Analysts differentiate between “headline” inflation and “core” inflation (which excludes the volatile elements of food and energy). Currently, there are yawning gaps between consumer-price inflation and producer-price inflation, and between headline and core inflation, primarily due to the impact of dramatic price rises in oil and food. The likely narrowing of these gaps is cause for concern. 

Inflation thrives in a low interest-rate environment, exposing the US economy in particular to additional risk. Elsewhere, the Bank of England and the European Central Bank have decided to hold rates steady and await further developments, but their policy dilemma remains: should they raise rates to head off inflation and risk an economic recession, or should they cut rates to aid the economy and risk fuelling further inflation?

This conundrum is particularly awkward for the ECB. While the Federal Reserve has clearly opted to rescue the US economy and the struggling banking system that lies at its core, the ECB’s primary obligation is to ensure price stability. However, the ECB will not want to be seen as the implicit architect of an economic slowdown because of a rigid adherence to its mandate; also, the ECB’s difficult position is compounded by the two-speed economic performance within its jurisdiction (a strong Germanic bloc contrasting with weakness in France, Italy and especially Spain).

In emerging markets, rising inflation is not only economically damaging (especially for countries whose currencies are pegged to the US dollar and who are therefore indirectly importing US monetary policy), but also a cause of political and social instability. Worryingly, the OECD expects food prices to remain high for the next ten years, due to increasing demand from e.g. the bio-fuels industry and developing countries like China.

While the deleveraging and capital rebuilding required to rejuvenate the financial sector will ultimately be disinflationary for the global economy, it is unlikely to completely offset the impact of higher food and oil prices. If oil supply fears persist, and if the OECD’s prediction is correct, consumers, central banks and investors have no choice but to prepare themselves for a lengthy period of high inflation.