Inflation returns to the global economy?

Economist Andrew Hunt looks at the prospect of rising inflation and what it means for the global economy. He suggests if inflation rates do rise bond markets may well be caught ‘off-guard’ over the next few months.

Friday, November 18th 2016, 9:44AM

by Andrew Hunt

Over recent weeks, many analysts around the world have become more optimistic over the outlook for world trade and this view has apparently been helped by some – although by no means all – of the most recent Asian trade data and by a partial rebound in PMI (Purchasing Managers’ Index) data in Europe and the USA.

Admittedly, we are usually quite sceptical of the ‘information value’ of the PMIs (in the 1990s we did find them useful but over recent years they seem to have become ‘endogenous’ or reflexive with regard to equity markets) but we do nevertheless have some considerable sympathy with the hypothesis that global trade values may be increasing once again following what would appear to have been an 18-month long slump.

However, we are also aware that the available data is not yet unambiguous on this topic. For example, if we observe the important and comprehensive CPB world trade volume data, we find that the trend in the data over the middle part of this year remained disappointing and that the IATA airline freight data, which is significantly more timely, has only become a little better over recent weeks.

Over the last decade or so, we have also found that Korea’s usually timely and reliable export data can often provide a useful ‘coal-miner’s canary’ for underlying world trade trends. If we observe Korea’s latest data, we find that although the country’s export growth in September was perhaps rather disappointing, in part as a result of a more demanding comparison point, there can be no doubting that the trend within the data has become decidedly less negative over the last few months (i.e. the three-month moving average for the data has been circa -4% as opposed to – 10% during the first quarter of this year).

At first sight, this would seem to be a positive result that rather contradicts the CPB data above but on further investigation we find that perhaps the most important feature of Korea’s export data was that the revival has not in fact been the result of better volumes but rather it has been driven by a reduction in the rate of dollar-denominated price deflation.

Only six months ago Korean export prices had fallen by 12% on a year on year basis but as of September this rate of deflation had dropped to minus 2%, a rate of deflation that we have in the past described as being essentially “neutral” for world inflation trends. Judging by this data, Korea is no longer exporting deflation, and, in fact, we find that Korean export prices have been rising on a sequential basis since March this year.

We suspect that some of the improvement in Korea’s export pricing data can be traced to the implied effects of the stronger Yen. Despite its loss of global market share, Japan remains an important price-setter in several important traded goods markets and there is still a surprisingly tight relationship between dollar-yen and world trade prices. On its own, the stronger Yen should have helped to relieve some of the bias towards global deflation.

Moreover, if we delve further into the detail of Korea’s export pricing data, we find that although the rise in inflation / reduction in deflation has been concentrated in the metals and hydro-carbon sectors, there has also been a reduction in deflation rates in the auto, machinery and electrical sectors.

Certainly, there would seem to be more ‘breadth’ to the data than simply the effect of changing commodity prices. At the same time, in other Asian export data releases, we find that China’s export prices also seem to have begun to rise, Taiwan’s export price index has stabilized and Japan’s dollar-denominated export prices have started to rise. Moreover, Japan’s export prices are no longer falling, a situation that is very different to last year’s 10% rate of export price deflation.

Given the behaviour of these various price indices, we are minded to believe that the apparent discrepancy between the still mixed / somewhat disappointing world trade volume data that CPB and to a lesser extent IATA are reporting, and the seemingly more upbeat Asian trade revenue data, is the result of a return of price inflation into many regional exports. This is something that will, of course, have ramifications that will extend far beyond Asia’s borders.

For many years we have reported in articles such as this just how falling global traded goods prices have suppressed inflation rates in the West even during times of seemingly strong domestic growth rates and we have also noted that most ‘inflation surprises’ (both positive and negative, inflationary and deflationary) have tended to occur not when inflation rates within service sector prices altered (which tends to happen only slowly and quite predictably) but instead when traded goods prices increased unexpectedly (or more accurately when the markets failed to note that traded goods prices were rising...)

Therefore, we can argue that with US service sector inflation rates currently running at around a 3.5% annualized rate at present (up from around 2.5% a year ago, largely we believe as a result of companies being obliged to pass on higher compliance costs to their customers), the news that import price deflation may be coming to an end implies that purely for arithmetic reasons, US core rates of CPI inflation could soon head for 2.5% - or higher. In this context, it is interesting to note that the US import price and PPI data releases are already suggesting a reduction in deflation / rise in prices and the latest ISM data pointed to a possible stabilization or even end in the trend towards import price deflation.

Certainly, if the trend to less negative or even positive rates of import price and goods price inflation continues, we can expect to witness a significantly increased rate of headline inflation for purely mathematical reasons. In reality, a consumer price index is little more than a weighted average of service sector and goods prices and with US service sector prices rising at 3.5% and goods prices stable, the rules of mathematics suggest that headline inflation should be moving towards the top end of the FOMC’s target band.

Currently, we do not believe that either bond or equity market valuations are prepared for this event and neither we might add are the central banks themselves.

Indeed, we are led to understand that the topics of discussion at the recent Jackson Hole central banking conflab were dominated by the subject of how to tackle deflation and while we may fear that central banks might have to return to this subject at a later date if the RMB were to be devalued next year, in the near term it looks to us that the biggest danger to inflation rates is upwards rather than downwards. This situation could of course catch the central banks off-guard and in so doing cause them problems in managing the financial markets’ expectations for policies and in particular for interest rates.

Certainly, if this scenario were to come to pass, then there would seem to be little or no reason to hold zero / negatively yielding bonds unless one believes that the central banks will continue to force bond prices higher through their sheer buying power even as inflation rates rise. In reality, we suspect that few central banks in the West will attempt such a feat (although Japan may...) and therefore, if inflation rates do rise as we expect, bond markets may well be caught ‘off-guard’ over the next few months.

Andrew Hunt International Economist London

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