Source : Business Times - 30 Apr 2008
OVER the last 150 years, in real terms, after allowing for inflation, commodity prices tend to fall. But the question is whether China and India are fundamentally changing this? The sheer scale of the demand for commodities as both countries open up will exert tremendous upward pressure on prices.
What remains to be seen is whether supply can respond. In terms of food prices, there is no shortage of land or labour, often the problem is low farm productivity and the absence of investment. That is, there needs to be a supply-side response, but that will take some time to be seen and, even then, it is not clear how effective it will be.
All in all, it adds to the perception that whilst commodity prices may ease during the coming cyclical slowdown, they will establish new, higher equilibrium levels, which whilst good for commodity exporters, will not be good for importers.
Former Fed chairman Alan Greenspan has come under criticism for not tightening monetary policy to curb asset price inflation earlier, but his response is understandable, he and the Fed can’t be blamed for the behaviour of private individuals, and for the fact that the asset price inflation seen in the United States was repeated in, as he said, about 20 other countries.
It has to be said that at the time there were many suggestions that the rapid pace of credit and lending growth and the rise in asset prices meant that monetary policy was too lax. Although Europe, it was said, opted for stability at the expense of growth, whilst the US favoured growth at the expense of stability, even within Europe there have been problems, with asset price inflation evident in a number of countries, such as Spain or Ireland.
In the late 1980s, a similar debate took place in Japan at a time when its economy was bubbling. Headline inflation was low, but asset prices were soaring. Then Bank of Japan (BOJ) governor Yasushi Mieno decided to tighten monetary policy, raising rates from 2 per cent to 6 per cent. The economy slumped! And the BOJ was partly blamed.
Thus it is vital to look at monetary growth and wider credit and liquidity. Measuring liquidity is hard; sometimes economists look at measures such as Marshallian k that look at monetary base in relation to an economy’s nominal GDP. Others prefer to look at overall monetary and credit growth. But, also, as has been seen in recent years, an increasing number of central banks have adopted inflation targets, although these may not give the full story.
What then should policy-makers do? It is important that they identify where the real problem lies. In the US, as we have said before, inflation is not the problem, a deep, long recession is. Firms will have to absorb higher costs in their margins, as weakening consumption means firms will not be able to pass on higher prices. In this environment the Fed will, rightly, ease, and as corporate profits are squeezed, bond yields will respond by heading lower.
In contrast, a number of countries that are tied to the dollar may see inflation problems escalate. Here, in particular, I am thinking of Hong Kong and the Gulf countries. Being tied to the dollar means lower interest rates, at a time when their buoyant domestic economies really need monetary tightening.
The result will be rising inflation, particularly asset prices, but also as wages have risen sharply across the Gulf, broader inflation measures may continue to rise. Of course, economies like China and India, where there has been strong domestic demand, have been tightening for some time with higher rates, rising reserve ratios and, in the case of China, loan quotas. China’s current account surplus gives it more room for policy manoeuvre. In the early 1990s, China suffered both inflation and a balance of payments problem.
Now, its external position is sound, and policymakers are more focused on inflation and trying to achieve a more sustainable pace of growth. In contrast, India’s deficit leaves its currency more vulnerable to near-term shifts in risk sentiment despite its many long-term positive factors.
As for Asian countries, policy-makers may opt for a combination of domestic monetary tightening or currency appreciation. For now, it seems many central banks are taking a proactive approach, with the attraction of currency appreciation to reduce imported costs potentially gathering ground.
Overall, there is still intense global competition. Furthermore the scope for large numbers of workers to join the global labour force, with low wages and potentially rising productivity, adds to the prospect of further competition for some time.
However, there is a need to look at each country’s situation on its own merits, taking into account credit and monetary growth, wage and inflation expectations, the amount of spare capacity and above all, the likely response of policy-makers.
Inflation may be a problem but the reality is far more complex and as Japan showed, an inflation fear, if badly handled, can soon turn into a deflationary reality.
By GERARD LYONS, chief economist and group head of global research Standard Chartered Bank, UK
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