Low rates of inflation have perplexed the world’s major central banks over the past two years, but the surprise over the year ahead could be inflation rising much more rapidly than anticipated.
Core inflation rates across the world’s advanced economies dropped to just 1.3 per cent last year, down from 1.5 per cent the year before, despite improving economic growth and falling rates of unemployment.
The “output gap” — the difference between what economies are producing now and their maximum sustainable potential output — is disappearing and, without that idle capacity, inflation should start to rise.
A jump in US consumer prices at the end of last year that was reported on Friday was seen by some economists as the first sign of building pricing pressure that would force the US Federal Reserve to lift rates more rapidly.
“It supports our view that the Fed will ultimately increase interest rates by a more aggressive 100 basis points cumulatively this year,” said the chief US economist at Capital Economics, Paul Ashworth.
Although too much cannot be read into a single month report, the December inflation report, showing prices rose 0.3 per cent, up from 0.1 per cent in November, was seized on because US unemployment is now down to a 17-year low of 4.1 per cent.
The inflation figures were released alongside retail sales showing a sharp lift in December and an upward revision to results for November. The latest labour force reports show US wage growth is rising, and is now up to an annual rate of 2.5 per cent.
With the Trump administration’s generous individual tax cuts kicking in from January 1, an economy already at full employment may start to show signs of overheating.
These concerns were reflected in a speech last week from New York Federal Reserve president William Dudley who warned that the Fed may have to “press harder on the brakes” at some point over the next few years.
The potential for inflation to lift this year is much broader than the US. JPMorgan economists are predicting a 0.5 percentage point lift in advanced nation inflation over this year.
They base this forecast on the increasingly synchronised nature of global growth, the tightness of labour markets and the final fading of the caution that has characterised both household spending and business investment since the global financial crisis.
Although the world economy has now been growing for nine years, 2017-18 is the first time that all major economies have been growing simultaneously. This is starting to boost prices of traded finished goods.
Until recently, low rates of unemployment have coincided with higher measures of underemployment and lower participation in the labour market. However, all measures of spare capacity in the labour market are now approaching the low points of the previous two expansions.
JPMorgan economists say that besides the strong consumer price index reading for December in the US, there are signs of a broader pick-up in inflation across Asia, including Japan, China and Taiwan, while business surveys are also pointing to a shift in the price outlook.
“The ingredients for rising core inflation are now in place and this move will encourage central banks to normalise their stances faster than current market pricing,” they said.
There is no definitive explanation for the weakness of inflation and wages across the advanced world, although most economists have suggested a mixture of globalisation, technology, weaker unionisation and simple slack in labour markets are responsible.
There is an economic debate over whether the increasingly global supply of goods and services means that the pricing power of workers in advanced nations is affected by their competition with workforces in emerging nations. Domestic unemployment rates may not provide a true measure of the supply of labour that business can call upon.
The IMF, in its last review of the economic outlook, said most of the weakness in inflation could be explained by the normal variations in supply and demand — evident in a rising share of the workforce on involuntary part-time contracts — and by the unusually weak productivity of advanced nations since the global financial crisis. They said the empirical evidence showed that a 1 percentage point increase in productivity growth is associated with a 0.7 percentage point lift in wage growth.
The fund’s sister organisation, the World Bank, provided a contrary perspective in its review of the global outlook released last week. It sharply upgraded its estimate of global economic growth — it now expects advanced economies to achieve growth of 2.2 per cent this year, up from a forecast six months ago of 1.8 per cent, while emerging nations will achieve growth of 4.7 per cent.
The World Bank says that poor productivity levels mean that economic growth is now approaching, or surpassing, the maximum sustainable or “potential” growth rate, which is a recipe for inflation.
“With output gaps closing or already closed in many countries, supporting aggregate demand with the use of cyclical policies is becoming less of a priority,” it says.
The World Bank worries that continuing to support economies with very easy monetary policies at a time when spare capacity is disappearing leaves the global economy vulnerable to financial disruption.
“There remain important downside risks. Disorderly financial market movements, such as an abrupt tightening of global financial conditions or a sudden rise in financial market volatility, could trigger financial turbulence and potentially derail the expansion,” it says.
The IMF will release its updated forecasts in a week. Its October update increased estimates for global growth but downgraded estimates for inflation. Both growth and inflation estimates are likely to be upgraded in its next round of forecasts.
Like many others, the IMF has struggled with its inflation forecasts. In its April 2013 economic outlook, it gave the chapter on inflation the heading “The dog that didn’t bark”, reflecting on the reasons why inflation had remained remarkably steady around 2 per cent despite the global financial crisis. The ink was barely dry on that report before inflation rates started to sink.
There have been hints Japan and Europe may withdraw stimulus more quickly as output rises. If inflation shows signs of returning to target zones, the still ultra-easy monetary policies would look completely misplaced.
In excellent comments provided by a reader: God help the Australian economy over reliant on indebted households driven by our immigration fuelled house prices. The need to improve our productivity and international competitiveness is greater than ever.
Published today by The Australian, link here. Posted here with permission of the author.