The inflation genie is back!

Malaysian Business, Nov 16, 2005 by Nor Zahidi Alias

INFLATION, deflation, disinflation, reflation and stagflation - these are among economic jargons that often confuse the man-in-the street. Among these, deflation is probably considered the most evil, although hyperinflation often gives the jitters to policy-makers.

A good example is Japan, where deflation has caused the economy to drag along for more than a decade without any meaningful recovery. Deflation squeezes corporate profits, which in turn leads to massive unemployment. Rising unemployment would cut further into profits as consumption sinks. This creates a vicious circle.

Recently, deflation has no longer been the favourite word in town. The inflation genie is back. News headlines these days indicate that price pressure is building up in most countries, thanks to escalating oil prices.

Headline inflation in the United States climbed at 1.2% month-on- month in September, the biggest jump in 25 years following high oil prices due to hurricanes Katrina and Rita that swept the coastal areas in August and September.

Even the Euro 12 region, where most countries are experiencing lacklustre growth, is bracing for higher prices. Germany recorded a 2.5% inflation rate in August while the region as a whole registered 2.6%, way above the European Central Bank's (ECB) target of 2%.

Japan, under a deflationary spell since the late 1990s, is also anticipating a return of inflation by 2006, according to the Bank of Japan.

Closer to home, inflationary pressure is also building up in Thailand, with the consumer price index (CPI) reaching 6% in September, the highest since September 1998, as the Thaksin administration decided to unwind its fuel subsidy for fear of raising the budget and current account deficits.

Indonesia's CPI escalated to 9.1% as the Government removed its fuel subsidy, causing widespread demonstration among the population. In Korea, the inflation rate jumped to 2.7% in August from the earlier month's 2% pace, a sign that price pressure is slowly picking up.

Not surprisingly, interest rates are also on the rise. In the United States, the Federal Reserve Bank (Fed) has been raising its policy rate - the federal funds rate (FFR) - since last June from a mere 1% to 3.75% currently. The rate is expected to continue rising to 4%-4.25% this year and possibly 5% by the middle of next year, according to economists. While the Fed initially did not give an impression that inflation would be a major threat to the economy, current statements from Fed officials obviously indicate the central bank's concern about rising price pressure in the economy.

A major question is - why are rising prices seen as a possible threat when core inflation is merely at 2% in the US? After all, the inflationary landscape in the US has changed dramatically in the past 10 years, with benign consumer prices as a result of rising productivity.

At the same time, Malaysia's economists are trying to guess how high the FFR will go as this could have important implications on Malaysia's overnight policy rate or OPR.

One crucial reason for the Fed to see this as a serious threat is that an increasing number of non-CPI indicators are showing upward price pressure. While the Fed prefers the so-called core private consumption expenditure deflator (Core PCE), economists also pay close attention to indicators like unit labour cost, Institute of Supply and Management (ISM) price index and inflation expectations in the financial market.

Unit labour cost, for instance, climbed by 4.3% in June, compared with its 35-year average of 3.8%, suggesting that employers will likely have to pass their costs to consumers sooner or later. The ISM price index is also above its 35-year average of 62.4 compared with 34.6 in December 2001, suggesting that prices in the manufacturing sector are on the rise.

The financial market is also flashing the red light for inflation. One common indicator is the difference between yields of US Treasury bonds and the so-called Treasury Inflation Protected Securities or TIPS. The difference in yields actually represents the financial market's expectation of future inflation.

For instance, the difference between yields for 10-year UST and 10- year TIPS represents the investors' perception of what the inflation rate would be in the next one decade. Looking at most of these indicators, one can conclude that price pressure is building up in the US economy.

The Fed is also concerned about the possibility of a housing bubble in the US. As long-term bond yields remain relatively benign, thanks to increasing demand from overseas, mortgage rates are kept low, inducing a majority of the population to snap up properties or refinance existing ones. Not surprisingly, median house prices are expected to climb by 11% this year, the strongest pace since 1980.

Under such a situation, the Fed feels a constant but slow rise in borrowing costs would eventually do the trick, bringing property prices down before they crash.

There's another good reason for the Fed to continue hiking up rates. American policy makers fear inflation simply because of what they experienced back in the early 1980s. High inflation was partly why President Jimmy Carter lost the election to Ronald Reagan in 1980. The CPI climbed to as high as 13.3% by the end of his administration from merely over 6% when he took office.