Inflation will take time to subside in a global recession

Posted on 06 August 2008 with no comments from readers

It is getting harder and harder this summer to find a country unaffected by economic recession or at least a substantial slowdown. The Gulf States and Russia stand out as economies still bursting with growth, and the trillion dollar infrastructure investment programmes in both should underpin growth for quite some time to come.

However, if you look at the official statistics then there is nothing to worry about. The UK has an inflation rate of around four per cent, according to these figures, while even the former Prime Minister John Major says at least 10 per cent is nearer the true figure.

It is the same story in the US. Food and energy costs are seen as items that distort official measures of inflation and are therefore excluded. That does not help pensioners struggling to pay their bills with incomes that are only designed to grow with the official inflation rate.

It is also bad news for investors who see the purchasing power of their money falling, even if it is sitting in so-called inflation protected treasury bonds. But this is nothing new.

The nineteenth century British statesman Benjamin Disraeli uttered the immortal line that there are ‘lies, damn lies and statistics’. Indeed, this seems more about the nature of statistics than a massive conspiracy over the centuries. Nonetheless, the lesson is that inflationary distortions require careful analysis and can not be dismissed as irrelevant.

Take the soaring cost of fuel. Oil prices have jumped from $50 to an all-time high of $147 this summer, and have now eased back a little. This increase is reflected in prices at the pumps, up 27 per cent in the UK over the past year but not included in consumer price inflation.

Yet it is not that simple. What will be included is the knock-on effect of the surge in gas prices. For example, the higher cost of an air-fare or delivery charges on goods. This is the time-lagged impact of inflation of a primary commodity like oil on the rest of the economy.

In the 1970s this was aggravated by a series of competitive salary rises and strikes for still higher incomes. This will a pattern repeated over the next few years as people try to save their living standards from the effect of inflation. Governments will try to resist this wage-price spiral but it will be difficult to achieve.

Take China, for example, where the Olympic Games are pointing the spotlight on its economy. Food and energy inflation have hit the Chinese economy hard this year, and the stock market has slumped by 50 per cent.

High oil prices have increased the cost of production in China directly and indirectly raised the price of finished goods through a surge in transportation costs. At the same time, big rises in food prices have been particularly tough for the poorest consumers. The social pressure for wage increases can only grow.

This is the inflation genie that the Federal Reserve has let out of the box with loose monetary policy designed to offset the impact of the sub prime crisis. It was always a risky plan and we see the result in higher oil prices and higher global inflation levels, even if the official figures under-report inflation at the moment.

If we remember the 1970s then it took from 1973 when oil prices trebled until 1982 – by which time the world economy had sunk into a nasty recession – for inflation to be brought under control. I doubt it will be possible to do it more quickly this time, although the economics could turn out to be different.

For the Gulf States this means that the good times will continue for some years yet. Oil prices have just dipped from record highs but a double-top in such inflationary times can not be ruled out, and prices could well rebound to the $150-200 peak predicted by Goldman Sachs during the next couple of years, and Gazprom’s $250 oil price forecast may be correct for 2009.

Certainly the borrowing by Dubai government entities this year, estimated last week at $32 billion against less than $10 billion in 2007, is an indication of the scale of investment in progress in the Gulf States. This factor alone would be enough to keep the good times rolling on going forward, and is doubtless matched by an equal munificence of foreign direct investment.

Domestic investment in Abu Dhabi and Qatar is equally impressive and Saudi Arabia is also investing big internally. But I don’t believe the days of high oil prices will be over anytime soon. The whole world is trapped in an inflationary spiral while most asset prices are in a deflationary downward spiral.

Eventually a new equilibrium will be reached – or rather a market bottom – from which asset prices can begin to inflate and by then consumer price inflation will be brought under control. However, that is many years away and this adjustment will have many casualties in terms of bankruptcies and unemployment.

It is going to be a rough time for global economies whose unprecedented expansion of the 2000s will now be followed by an unprecedented contraction. But in order to make this as painless as possible loose monetary policy is necessary and that will continue to support the oil price far longer than many sceptics believe possible.

In this scenario the Gulf States will be able to borrow cheaply to fund their massive infrastructure programs and enjoy very strong oil and gas revenues. The party is far from over yet.