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Brazil’s 50bp rate hike this week was insufficient to meet the challenges of an economy well beyond capacity and rising inflation expectations). With monetary policy likely to remain soft and with global commodity prices under upward pressure, what central banks say and what they do are not consistent. Further, people’s experience of higher inflation, especially of food, is likely to push inflation expectations up. This will not be welcome in many countries. But in the US, higher inflation expectations are probably a policy goal. Clearly, inflation expectations are low and falling. Clearly, there is massive excess capacity, especially in the labour market. Clearly, wages are weak and so are unit labour costs. Therefore there is a real and present danger of disinflation and even of deflation. Interest rates are at their zero lower bound and, despite QE, there seems to have been a ‘liquidity trap’ like behaviour of long-term yields – with the central bank unable to get them low enough to bring the economy back to full employment. So how is the Fed to avoid disinflation? The traditional means is to narrow the output gap sufficiently to end the threat. But the gap is too wide. Moreover, since the ability to lower short-term rates is gone and the ability to lower long-term rates enough is lacking, the output gap will stay wide. So the main means of fighting inflation is to raise expectations of inflation down the road. Firms and individuals expecting inflation at a future date, when spare capacity is reduced, will price differently and act differently today. That is what “considerable period” was about in 2003 and it’s what QE2 is about today. In short, to overcome deflation today, look as though you will create inflation tomorrow. It’s like telling central banks facing deflation that the responsible thing to do is to be irresponsible. There are plenty of people who think QE2 is irresponsible – the Chinese, for example. You can criticise the Fed for pursuing a policy that will create inflation the day after tomorrow. But if the alternative is deflation today, is that such a bad policy? While the threat of disinflation remains real in the US – which is to say while payroll growth remains insufficient to significantly lower unemployment and while wages and pricing power remain subdued – then it would be wrong for the Fed to do anything other than to create expectations of future inflation. Thus we would expect that policy to persist “for an extended period”. The Fed’s ability to create inflation in the domestic economy is limited by the slackness of the labour market. Because of this and the fact that what people experience is an important part of expectations formation, it follows that to create expectations of inflation, it has to create expectations of inflation in import prices. In other words, the Fed probably wants to see global inflation high at present, or a weak dollar, or both. We can argue that an increase in oil prices is the “wrong sort of inflation” since it “taxes” consumers, but if the choice is between the wrong sort of inflation and deflation, then the Fed would probably take the former. The Fed has made explicit that its aim is to raise inflation, because US inflation is too low. If countries peg or dirty float against the USD, they are implicitly adopting a target to raise their own inflation rates. Since their inflation rates are above the US and in some cases already too high, the implication is that we should expect inflation expectations in their economies to rise. Summary • The global output gap is very small and may have closed. We look like going well beyond capacity in the next couple of years. The fact that capacity utilisation is very uneven raises the global inflation threat; • Commodity price shocks are likely to continue due to the lagged effects of La Niña and global warming, though next year some of these effects may decline; • Monetary policy on a global basis is too slack, especially in Asia. US policy is amongst the slackest. While this is appropriate for the US, exchange rate arrangements may mean this is imported into inappropriate settings such as EMs; • Inflationary expectations are very low in North America. Elsewhere, they are moderate to high. The objective of the US is to avoid deflation by raising inflation expectations. Countries limiting the appreciation of their currency are importing the Fed’s objective of raising inflation. • The risks of global inflation are high. Capacity is tight, monetary policy is slack and central banks are acting weak. The discipline of pegging to the reserve currency is gone from much of the world because the reserve currency has an ultra-easy policy and is aiming to raise inflation. The risk of a surge of inflation and a dislocation of inflation expectations is high in many countries; and • The key thing to watch is inflation expectations. They have declined from their ‘scare’ levels last year but the wild swings over the last couple of years show they have become unstable. Paul Mortimer-Lee 20 January 2011 Market Mover 8 www.GlobalMarkets.bnpparibas.com
Chart 9: Asia- Ifo Expected Inflation Chart 10: North America- Ifo Expected Inflation Source: Reuters EcoWin Pro Source: Reuters EcoWin Pro Chart 11: W, Europe- Ifo Expected Inflation Chart 12: CIS- Ifo Expected Inflation Source: Reuters EcoWin Pro Source: Reuters EcoWin Pro Chart 13: Eastern Europe- Ifo Expected Inflation Chart 14: Latam- Ifo Expected Inflation Source: Reuters EcoWin Pro Source: Reuters EcoWin Pro Paul Mortimer-Lee 20 January 2011 Market Mover 9 www.GlobalMarkets.bnpparibas.com
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Travelling Asia • Inflation has e
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Capitalism requires business cycles
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EURUSD Rally Eyes 1.3750-1.3950 •
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Currency Spot Trade Recommendations
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than an unrelenting rise in prices
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Economic Calendar: 21 - 28 January
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Key Data Preview 120 115 110 105 10
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Key Data Preview Chart 5: French Sa
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Key Data Preview 10 5 0 -5 -10 -15
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Key Data Preview 3 2 1 0 -1 Chart 1
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Economic Calendar: 31 Jan - 25 Feb
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Next Week's T-Bills Supply Date Cou
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Economic Forecasts GDP Year 2010 20
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Market Coverage Market Economics Pa
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