03 April 2008

Analysis: Inflation is the macro surprise of 2008

INTERNATIONAL. The macro surprise of the year so far has been the upside surge in inflation, not the downside cut to growth. Since it launched its forecasts four months ago, Merrill Lynch economists have ratcheted up 2008 global inflation expectations by a full 0.8ppt, from 3.4% to 4.2%, while shaving growth just by 0.2ppt. The threat of inflation at the global level is real, they say.

In a new report Merrill Lynch looks at ten different ways of analysing inflation. Seven of its ten indicators show bubbling inflation. Most worrying are tightness in food and energy markets, surging money supply growth, repressed inflation in emerging markets, the reaction function of central banks and the continued central bank financing of the US current account deficit. Deflationists can point to still no evidence of accelerating unit labour cost growth and to a cyclical growth downturn emanating from the United States.

In nearly all of the measures of inflation, the threat in emerging markets is greater than in the United States, where rising inflation is less likely against a weakening labour market and deflating home prices. The threat to US inflation would come primarily from emerging markets allowing their currencies to appreciate dramatically, thereby “exporting” some of their inflation back to the US.

Given the view of Merrill Lynch that the rest of the world should remain better protected from a US downturn than consensus expects, there is concern about global upside inflation risks. The report takes the opinion that the current global economic expansion will come to an end when emerging market central banks decide to deal with this threat more aggressively. In Dubai, Sheikh Mohammed, Ruler of Dubai and Prime Minister of the UAE said just this week that a committee had been formed to study the de-pegging of the UAE Dirham to the US Dollar. It will report at the end of this year. Watch out for aggressive policy tightening, civil unrest among labour workers, or capacity constraints. But we are not there yet.

So where now for global inflation? It depends on which economist you ask. Some highlight the labour market as the main driver, some insist that money is the only determinant of prices in the long run, and others yet focus on the elusive inflation expectations.

Rather than focusing on one particular theory of inflation, what Merrill Lynch did in this report was examine every theory it could think of. Does this wide array of theories point to a common conclusion?

Here are ten theories of inflation and what each implies for the future.

1. Policy reaction function: HOT
In recent years, central banks have behaved asymmetrically: easing more aggressively than tightening, easing quickly but normalising slowly and easing both when inflation falls and when inflation rises too much. We would expect an upward trend in inflation as a result.

2. Food and energy: BOILING
Most economists think of commodity prices as exogenous, yet they are clearly not for the global economy as a whole. We find that commodity prices have been driven higher by emerging market demand growth. Thus, a substantial tightening in policy conditions in those countries is a prerequisite for any medium-term downward correction. The longer-term outlook for food and energy prices remains favourable as emerging market demand has a long way to go and supply is constrained. Over the near term, central bankers and others are worried about further commodity price “super-spikes”. Thus, regulators and markets that focus on core rather than headline inflation do so at their own risk.

3. Output gap: NEUTRAL
Emerging economies have almost reached the point where capacity-constrained supply will not be able to meet strong demand, thereby starting to generate inflation. In the developed world, the output gap has closed rapidly in both the Euro area and Japan, while it has slipped into negative territory in the US. Below-trend growth is necessary to arrest this factor.

4. Labour markets: COLD
Labour markets are increasingly tightening. Coupled in some cases with sluggish productivity, this is gradually leading to a pick-up in wage growth and labour costs. These trends are most evident in emerging, not developed, markets. Despite a recent pick-up, however, unit labour cost growth remains well contained at a global level. Any spillover from tightening labour markets into higher inflation
remains a forecast, rather than a reality.

5. Money and credit: HOT
Merrill Lynch finds that global money supply is currently growing at a rapid rate, having accelerated clearly above its long-term trend over the recent past. The current rise in global inflation might be a reflection of the above-trend money supply growth over the past two years. As of the beginning of this year, we find no evidence of a slowdown in global money and credit growth sufficient to help contain inflationary pressures over time. The recent US credit crisis might eventually contain money growth, but it hasn’t done so yet.

6. Globalisation and the effect of China: GETTING HOTTER
The days of low global inflation could be numbered, as China’s once-vast labour supply begins to run dry. Low Chinese wage costs, driven by wide-scale integration of the Chinese workforce into the world economy, have underpinned the virtuous cycle of strong growth, low inflation, soft real rates and high profitability. The good news is that we are not quite there yet. Although Chinese wages are rising, there are still some 50 million workers to go. The bad news is that the end may come sooner than most people think, as early as 2009-2010.

7. Repressed inflation in emerging markets: HOT
Repressed inflation measures inflationary pressures that the government suppresses by administrative fiat, whether through administrative controls, subsidies, or export/import bans. This is particularly prevalent in emerging markets in Asia, the Gulf, and Latin America, and in goods such as oil, food, metals and electricity. We can expect such measures to persist for the foreseeable future and to be lifted only gradually. Such measures lead to suboptimal allocation of resources, transfer the onus of reduced consumption for commodities back to countries – particularly in the developed world – that don’t feature them, support infrastructure plays, and constitute a long-term inflation threat in the event commodity prices do not subside.

8. Inflation expectations, credibility: GETTING HOTTER
Currently, survey-based measures of inflation expectations show remarkable stability in the United States and the Euro area, but are drifting higher in Japan. Market-implied measures of inflation have drifted slightly higher in the US and the UK (though not in the Euro area) and have also shown an upward tendency in
some emerging markets.

9. Currency effects: NEUTRAL
Exchange rates have no effect on the total level of global inflation. However, exchange rates are relevant in the distribution of global inflation across countries. In an environment with a falling US Dollar, countries with their currency implicitly or explicitly pegged to the greenback (such as the Gulf and Hong Kong) will
experience greater inflationary pressures. Accordingly, exchange rate pass-through adds to inflationary pressures in the US (as imports to the US become more expensive) and decreases inflationary pressures for US trading partners with floating exchange rate regimes (as imports from the US become less expensive).

10. The inflation endgame: HOT
Inflation is the natural endgame to 'Bretton Woods II', the international financial system whereby the bulk of the US current account deficit is financed by central bank intervention in emerging markets such as China, the Gulf and Russia. By intervening to support the US Dollar, these central banks effectively expand domestic money supply and add to upward inflationary pressures. Eventually the system reaches its natural endpoint, when pressures become too high to tolerate and the lesser evil of currency appreciation is chosen. Merrill Lynch expects this to take place in 2008. Such appreciation would effectively 'export' these inflationary pressures back to the US. The good news is that current estimates suggest very small inflation pass-through from a weaker US Dollar, though such estimates are notoriously unstable.

What about lags?

Some investors see the recent run-up in inflationary pressures as cyclical, and expect the current global growth downturn to arrest inflation, with some lag. The report makes several comments on this.

First, inflation has accelerated sharply as the US credit crisis has unfolded. To put it differently, if you were told nine months ago that the US would be going into a recession, you would not have expected oil prices above US$100 per barrel. This is not a product of lags, the report says, but of a mistaken view on the source of the pressures.

Second, the source of the inflationary pressures is not the United States but the rest of the world, which has not slowed down sharply as the US credit crisis has unfolded and whose central banks continue to fund their expansion.

Third, inflationary pressures are cumulative, not marginal. The longer you grow above trend, the faster inflation accelerates. Inflation is a non-linear process.

Because of the longevity of the current global boom, a substantial downturn is required to alleviate bottlenecks. A shallow growth downturn will not do the trick.

Focusing on inflation cyclicality misses the point: after many years of growth, particularly in emerging markets, the global economy has reached its capacity constraints and thus the growth/inflation trade-off has now changed. This creates a different investment backdrop from the 1990s whether or not you get any temporary cyclical inflation respite.

What next?

The repercussions of inflation can manifest themselves in a number of ways. First, policy could be tightened. Ideally this would happen via currency tightening in the emerging markets world, thought it is more likely to come in a cocktail of currency tightening, higher interest rates and quantitative measures.

Second, civil unrest could ensue, if authorities do not act decisively to contain inflation. Inflation disproportionately affects those on fixed incomes, with few assets or with a greater weight of food in their consumption basket. Watch out for simmering discontent.

Third, capacity constraints could become increasingly common. These can take a number of forms such as power blackouts, physical shortages, or more frequent interruption of production as a result of seemingly random events such as extreme weather.

A natural starting point in trying to predict inflation is to examine how policy makers themselves conduct policy. Merrill Lynch argues that in recent years central banks have behaved asymmetrically: easing more aggressively than they have tightened, easing quickly but normalising slowly and easing both when inflation falls and when inflation rises too much. We would expect an upward trend in inflation as a result.

Central banks ease more aggressively than they tighten

First, central banks have been more aggressive in their easing than in their tightening campaigns. This means that easing cycles have been faster and deeper – but shorter in duration – than hiking cycles. For example, this decade, the probability of a rate cut in any particular quarter (28%) has been slightly smaller than the probability of a rate hike (33%). However, the probability of an aggressive rate cut – say more than 50bp – (59%) has been nearly double that of an aggressive rate hike (32%). By aggressively protecting the downside more than limiting the upside, central banks over time slowly shift agent expectations higher.

Fed Governor Mishkin has rebutted such criticism by arguing that central banks rightly react more aggressively to downside growth surprises because they tend to happen faster, and with shorter notice, than upside growth surprises. In effect, Governor Mishkin argues that recessions are infrequent – but highly damaging – events and thus central banks need to be aggressive in dealing with them.

There is indeed some evidence in support of this theory with the distribution of growth surprises skewed to the left in line with that of rate surprises. However, this would also imply that the central bank should be quick to normalise rates when growth itself normalises; we do not find that to be the case.

Central banks ease quickly, but normalise slowly

When global growth drops below trend, it does so quickly, and central banks react accordingly. Merrill Lynch finds that three quarters after a dip below trend, growth has slowed by an average of 1.5ppt, and central banks have eased an average of 90bp.

When growth rebounds above its trend, however, the reaction is slower. Three quarters after the dip above trend, growth has accelerated by an average of 1ppt, and central banks have tightened by just 14bp.

Asymmetry in inflation target as well

This asymmetry carries through into reactions relative to a central bank’s inflation target. Most major central banks have adopted some form of explicit (or implicit) inflation target with lower and upper comfort bands. The report estimate sthe central bank reaction as inflation approaches these upper/lower bands. It finds that central banks on average cut 5bp when inflation reaches within half a percentage point of the lower end of their comfort zone; but they also cut 4bp when inflation reaches within half a percentage point of the higher end of their comfort zone.

This counterintuitive result could be explained by the extent to which inflation is a lagging indicator; and forward-looking central banks are focused on downside risks to growth by the time actual inflation is approaching their upper limit. But this explanation would not account for the former result, in other words why central banks cut as their lower limit is reached.

The fight against deflation inevitably produces inflation. It is often said that policy mistakes are the product of an attempt to avoid repeating previous policy mistakes. The report concludes that the three behavioural patterns described above have been the natural by-product of a policy of ensuring that Japan’s experience of deflation is not repeated in other countries. Having concluded that the Bank of Japan’s main policy error in the early 1990s was to fail to ease monetary policy soon enough after asset deflation ensued, the report concludes that that policymakers adopted a much more aggressive stance towards protecting the downside in the decade that followed. Further strengthening this was the general acceptance that the war against inflation had been won (a war fought in the 1980s as a result of policy errors made in the 1970s) with inflation expectations contained, allowing central banks to pursue 'opportunistic inflation'.

The logical endpoint to this, of course, is a general upward drift in inflation until lower band, upper band central banks’ tolerance on the upside is once again tested.

What about emerging markets?

The report attempted to replicate the results above in emerging markets. However, the countries are not homogeneous enough (in trend growth, or target inflation rates) to draw firm conclusions. Nevertheless, it is evident that the relationship between growth, inflation and central bank rates is less clear-cut than in the developed world, and our main conclusion is that many emerging markets have a greater variety of policy targets (implicit or explicit) than just inflation. These often include explicit growth targets, such as that quoted at the beginning of this section as well as other variables. As a result, central bank tolerance of inflation in emerging markets is higher than in the developed world.

When forecasting growth and inflation, most economists tend to think of commodity prices as exogenously determined. Viewed through this mirror, higher commodity prices undoubtedly lower growth and increase inflation. Many central banks also focus on core, not headline, inflation, assuming commodity prices are
either mean-reverting or cannot be consistently influenced by monetary policy.

Yet both views are obviously incorrect at a global (general equilibrium) level, where commodity prices, inflation and growth have to be jointly determined. All else being equal, stronger demand growth should be correlated with higher, not lower, commodity prices. Indeed, this has been the case during the past decade.

Thus, any forecast of global inflation needs to include a forecast of commodity prices. Are we getting close to the end of the commodity price rally? What would bring about a substantial correction lower? Merril Lynch concludes that commodity prices have been driven higher by emerging market demand growth, and a substantial tightening in policy conditions in those countries is a pre-requisite for any medium-term downward correction. The longer-term outlook for food and energy prices remains favourable as emerging market demand has a long way to go and supply is constrained.

Of course, the situation is not the same in every commodity market. Agricultural commodities tend to follow short cycles as a result of production dynamics and fierce competition. However, the oil sector is facing a much darker future. Our long-term oil supply outlook is bleak, according to Merrill Lynch, partly because non-OPEC production is predicted to peak in the next five years. The cost of developing ultra-deep, arctic or oil sands reserves has continued to increase in recent years, and the ability of large oil companies to produce this hard-to-extract oil is limited.

As the world becomes more dependent on OPEC, which is essentially a cartel controlling the world’s most precious commodity, prices are unlikely to come crashing down.

Nevertheless, commodities have only a weak link to OECD inflation

The limited ability of commodity producers to expand supply ultimately means that emerging markets will continue to face a trade-off between inflation and growth. These inflationary pressures coming from the commodities side could ultimately have an impact on terms of trade, potentially putting some upward pressure on OECD inflation in the long run. However, commodities themselves maintain only a very weak link to OECD inflation.

Longer-term, energy efficiency and technology hold the key

Commodity supply growth will likely continue to disappoint due to a combination of resource, labour and equipment constraints. Growing commodity demand from emerging markets will put upward pressure on commodity prices, and possibly emerging market inflation, for years. However, we also believe that the market will help devise alternative solutions. Longer-term, energy efficiency and new technology will hold the key to commodity price movements.

In particular, energy efficiency and new technologies will help countries like China to continue to enhance the relationship between energy and economic growth. Of course, higher prices will ultimately force more efficiency in energy and food consumption.

Moreover, further developments in biological sciences may boost agricultural productivity, helping to resolve the acute water and land shortages that the world faces today. And new technological breakthroughs in the energy sector will enable the global economy to continue to grow strongly in the 21st century and beyond.

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Lebanon Time-Line

Introducing Lebanon

Coolly combining the ancient with the ultramodern, Lebanon is one of the most captivating countries in the Middle East. From the Phoenician findings of Tyre (Sour) and Roman Baalbek's tremendous temple to Beirut's BO18 and Bernard Khoury's modern movement, the span of Lebanon's history leaves many visitors spinning. Tripoli (Trablous) is considered to have the best souk in the country and is famous for its Mamluk architecture. It's well equipped with a taste of modernity as well; Jounieh, formerly a sleepy fishing village, is a town alive with nightclubs and glitz on summer weekends.

With all of the Middle East's best bits - warm and welcoming people, mind-blowing history and considerable culture, Lebanon is also the antithesis of many people's imaginings of the Middle East: mostly mountainous with skiing to boot, it's also laid-back, liberal and fun. While Beirut is fast becoming the region's party place, Lebanon is working hard to recapture its crown as the 'Paris of the Orient'.

The rejuvenation of the Beirut Central District is one of the largest, most ambitious urban redevelopment projects ever undertaken. Travellers will find the excitement surrounding this and other developments and designs palpable - and very infectious.

Finally, Lebanon's cuisine is considered the richest of the region. From hummus to hommard (lobster), you'll dine like a king. With legendary sights, hospitality, food and nightlife, what more could a traveller want?

Introducing Beirut

What Beirut is depends entirely on where you are. If you’re gazing at the beautifully reconstructed colonial relics and mosques of central Beirut’s Downtown, the city is a triumph of rejuvenation over disaster.

If you’re in the young, vibrant neighbourhoods of Gemmayzeh or Achrafiye, Beirut is about living for the moment: partying, eating and drinking as if there’s no tomorrow. If you’re standing in the shadow of buildings still peppered with bullet holes, or walking the Green Line with an elderly resident, it’s a city of bitter memories and a dark past. If you’re with Beirut’s Armenians, Beirut is about salvation; if you’re with its handful of Jews, it’s about hiding your true identity. Here you’ll find the freest gay scene in the Arab Middle East, yet homosexuality is still illegal. If you’re in one of Beirut’s southern refugee camps, Beirut is about sorrow and displacement; other southern districts are considered a base for paramilitary operations and south Beirut is home to infamous Hezbollah secretary general, Hassan Nasrallah. For some, it’s a city of fear; for others, freedom.

Throw in maniacal drivers, air pollution from old, smoking Mercedes taxis, world-class universities, bars to rival Soho and coffee thicker than mud, political demonstrations, and swimming pools awash with more silicone than Miami. Add people so friendly you’ll swear it can’t be true, a political situation existing on a knife-edge, internationally renowned museums and gallery openings that continue in the face of explosions, assassinations and power cuts, and you’ll find that you’ve never experienced a capital city quite so alive and kicking – despite its frequent volatility.