Inflation-inducing scenarios loom over the global economy as 2011 eases out and 2012 slips in, but how all the elements come together in the next few months will be a key to just how high prices rise and how long they stay there.
As the close of the year, the U.S. continues to limp along at a very slow growth rate. Consumer prices in the U.S. picked-up in recent months, with headline inflation surging mid-year . And, the U.S. Federal Reserve is heading into its third year of a near zero-interest rate policy.
What are the risks for additional inflation? Could the record levels of liquidity pumped into the financial system from the U.S. Fed ultimately create massive inflation ahead? Or, on the other side of the coin, with the U.S. slow-growth scenario still concerning economists, is deflation actually a risk here? On a global front, economists note that a sort of “two-track” inflation outlook is arising—with emerging economies showing rising levels of inflation, while advanced economies remain on a slow inflation track, primarily due to low growth.
A primary focus is on the U.S., with economic forecasts for the 2012 and what this could all mean on the inflation/deflation front.
U.S. GROWTH OUTLOOK
When considering an inflation or deflation outlook, one must first take a look at overall growth prospects. Some economists say that the eurozone may actually already be in a recession. Meanwhile, recent U.S. economic data has posted marginal improvement, though overall growth remains lack-luster and below trend.
After posting a 3.0% GDP rate in 2010, the U.S. is on track for an estimated 2011 growth rate of 1.7%, according to Credit Suisse. Looking ahead into 2012, Credit Suisse forecasts a 2.1% GDP pace. Not recessionary, but certainly not strong growth either.
Looking at consumer price index data, 2010 saw the U.S. post a 1.6% year-over-year CPI reading. In 2011, however, that is estimated to show a spike higher to a 3.2% annual rate, according to Credit Suisse. Into 2012, Credit Suisse forecasts moderation back to the 1.7% level for CPI for the year.
However, looking at the core rate of CPI, which excludes food and energy, that also saw a bump up from a 1.0% level in 2010 to an estimated 1.7% reading for 2011. That is forecast to continue edging higher to 1.9% in 2012, according to Credit Suisse.
What caused the bump up in core inflation in 2011?
“A year ago we had just come through the period with the lowest 12-month core [CPI] rate since 1960,” said David Resler, chief U.S. economist at Nomura. “In the past year, it has accelerated by a full percentage point. However, much of it was driven by temporary factors,” he said.
INFLATION BOOSTERS
Resler pointed to the “sharp acceleration in new and used vehicle prices” as one factor supporting the bump up in core inflation in 2011. “That happened just after the tsunami hit Japan. When you have a big reduction in supply, prices usually go up,” Resler said.
However, he noted that vehicle prices have already started to come back down. Another factor bolstering the core rate of inflation is the “pass-through effect of [higher] energy prices. That too is likely to prove temporary,” he said.
Finally, a third factor sparking higher inflation levels was that the “mortgage and housing crisis has created a big surge in demand for rental properties. House rents have been rising,” Resler said.
Overall, however, Resler sees muted inflationary pressures ahead. “Most of the things that caused the core inflation are already reversing or will begin to reverse,” he said. Nomura estimates that core CPI inflation will total 2.1% in 2011, but then drop back down to 1.4% in 2012.
Asha Bangalore, senior vice president and economist at Northern Trust Bank agreed with Resler’s view. “Demand is not robust [enough] to ignite higher inflation —overall and core. Given the fact that the EU is most likely to experience a recession, Brazil, India, and China are experiencing weakness, and Japan has its own challenges, world demand for commodities is not likely to translate into rising prices. With respect to the core CPI, housing is the largest component. Housing costs are moving up but there is no major threat of inflation,” she said.
WEAK LABOR MARKET
The U.S. Federal Reserve, with its dual mandate to contain inflation and promote employment, is not currently concerned about inflation, Resler said. “The issue for the Fed is the unemployment rate.” While the overall U.S. unemployment rate has dipped down slightly to the 8.6% level towards the end of 2011, it saw a mid-year push above the 9.0% level, uncomfortably high for the U.S.
In fact, the weak labor market may be a key factor holding inflation down in the months ahead in the U.S., some economists said.
“Wages are barely growing,” said John Lonski, chief economist at Moody’s Capital Markets Group. In fact, he sees stagnant wage growth in the U.S. ahead. “It’s going to be difficult to significantly reduce unemployment without a softening of wages. You are going to have a reduction in real average wages in order to reduce unemployment substantially,” Lonski said. This type of scenario simply doesn’t offer businesses any pricing power to increase the cost of goods.
“I don’t see it [inflation] getting much faster. When you have such high unemployment, businesses have the ability to keep wages down. Businesses can’t raise prices,” said Jeff Rosen, economist at Briefing.com. “There’s nothing on the horizon that suggests inflation will be rising.”
However, Rosen conceded that headline inflation or the rate that does include food and energy is vulnerable to a pop higher in 2012. “If we seen another shock in food or another Arab Spring event, we could see prices move up,” he warned.
HYPERINFLATION THREAT?
Some market watchers, however, have highlighted concerns about inflation or even hyper-inflation in the wake of the U.S. Fed’s massive stimulus programs, which included quantitative easing and QE2. Critics of the stimulus warned this could ultimately result in high inflation down the road once the U.S. economy rebounded.
In fact, part of the current slow growth problem is that banks are not lending and there simply isn’t demand for borrowing right now, economists said. Businesses are hesitant to borrow with all the current economic uncertainty swirling around. So, the additional liquidity from the Fed simply isn’t roiling around in the financial system right now.
“As long as banks hold excess reserves and are not extending credit, inflation is not a concern. It will be worrisome if bank start lending at a strong clip,” said Northern Trust’s Bangalore.
“The worry is that if the economy reverses back and banks snap their fingers and start lending again, there is a lot of available credit and liquidity. There is a risk that a lot of money could enter the system really quickly,” said Briefing’s Rosen. But, that is “contingent on the economy turning around and growing really quickly, which doesn’t seem likely,” he added.
Even if it did, Rosen believed the Fed could contain that situation. “If that were to happen, the Fed could just tighten the screws to limit liquidity and limit the extra money supply,” he explained.
THE OTHER SIDE OF THE COIN
It wasn’t too long ago that concerns about a Japan-like deflationary spiral were circulating about the U.S. economy, are those worries now in the rear view mirror?
“Deflation is not a concern, the economy is growing and Fed has succeeded in turning the tide here,” said Northern Trust’s Bangalore.
However, others remain wary. “You can’t rule it out. There was a risk of that a year ago,” said Beth Ann Bovino, deputy chief economist at Standard & Poor’s. Core CPI fell to a 0.6% level in the fourth quarter of 2010.
What exactly is deflation? Bovino offered this definition. “If everybody saves, nobody spends, businesses don’t hire, products don’t get sold and prices fall further and further,” she said.
Japan became mired in such a scenario during the 1990s and as the Bank of Japan discovered deflation is a hard nut to crack. Economists actually say that central banks have more policy tools at their disposal to tackle rising levels of inflation as opposed to falling levels of deflation. While some critics may wonder about the impact that QE2 had on the U.S. economy, Bovino calls it a success story merely because “it was very helpful in preventing the U.S. from falling into a deflationary spiral.”
Overall, economists appear to be more concerned about the potential for deflation on the horizon, than actual inflation in the U.S.
“We don’t see this [deflation] as a likelihood but there is some potential,” said Nomura’s Resler.
What factors would need to unfold to spark actual deflation? Resler said “it would probably take another retreat into recession.”
Moody’s Lonski added that in the U.S. currently, “real wage deflation is underway. That presents a risk for consumer spending and housing. If we are going to have a severe market disruption in the next 12 months it is much more likely to be because of price deflation than price inflation. The 1970s are not likely to recur anytime soon,” he said.
Kitco News-December 19, 2011