Low interest rates a distant memory
The second half of 2007 will be remembered as economically subdued, but with extremely volatile financial markets, as the credit crunch hampered the US and, to a lesser extent, world growth prospects. In the main this also forced policy makers, but not the Reserve Bank of Australia (RBA), to put aside inflation concerns.
As figure 1 shows, the general trend in commodity prices, as measured by the US-centric CRB index, continues to register new highs. This contradicts fearful pronouncements of an imminent US and global recession. The commodity markets suggest no such slow-down has yet to be sighted.
The inflation of commodity prices has been driven, to some extent, by the extraordinary rise in the price of US crude oil, its value reaching of the US$100-a-barrel mark in recent times.
But rising energy prices are not the only driver of inflation. Wheat and other grains, as bellwether foodstuffs, have also exhibited some extraordinary moves over and above those seen in previous seasonal price cycles.
These significant price rises are partially explained by the rise in demand for commodities, but also by a weak US dollar pushing up world inflation. The steep decline in the value of the dollar renders these commodities relatively cheap to non-US-dollar-based buyers. This means these buyers can bid up the dollar price of commodities using their harder home currency, further feeding the demand / price spiral.
Despite mediocre G7 economic prospects, growth in the non-G7 economies has been running at more than 5 per cent for the past four to five years. Forecasts produced by the International Monetary Fund suggest this trend will continue. Above-average world growth will ensure the price of commodities and other goods and services will remain on the high side.
The US headline inflation rate is already worrying inflation / interest rate watchers. As figure 2 shows, the headline consumer price index is back at decade highs of 4.3 per cent (at last count). These price rises will inevitably force the Federal Reserve's hand into 2008. It will concentrate on containing core inflation to under 2 per cent. Headline rates of more than 4 per cent do not make its job any easier. And a weaker US dollar will make the cost of US imports more expensive, feeding directly into consumer prices.
In Europe the picture is the same, with inflation having reached two decade highs of more than 3 per cent, well above its definition of price stability, at around the 2 per cent inflation mark. This super economy (even larger than the US), is starting 2008 with a significant inflation risk that must be addressed.
The rise in commodity prices, combined with the recent falls in the dollar and persistent growth in the global economy, all point to inflation as an emerging 2008 problem. This is even without revisiting the heated growth-inflation story in India and China, mentioned in past articles.
It could be argued that the recent two quarters of subprime-related market volatility has managed to both grab headlines and cloud the expectations of inflation. Its relative importance to central bank policy took a back seat while the Federal Reserve, the European Central Bank (ECB) and other central banks sought to stabilise credit markets. Current data shows that inflation is destined to be the major financial problem that will characterise 2008 and beyond.
Rising global inflation coupled with a very weak US dollar and essentially intact growth trends can only put pressure on Australia's own domestic cost and inflation rate structures, and global interest rates.
The Federal Reserve and the ECB, like the RBA, can choose to ignore the trends in their core inflation measures. But if they do, and do not readjust short-term interest rates upward, then there's the risk that longend interest rates will rise anyway as investors seek to compensate for the increased inflation risk.
While inflation remains a global problem lower interest rates in Australia are likely to be a long time in coming.
Peter Pontikis FCPA is the group treasury strategist for Suncorp and a member of CPA Australia. The views expressed here represent his analysis and do not purport to represent Suncorp's views.
Further information
Reference: March 2008, volume 78:02, p. 18
