From Goldilocks to Stagflation

21^st December 2007
The Malta Independent - Friday Wisdom

After a long period of benign inflation and relatively high economic growth it appears that quite unexpectedly the international economic landscape is changing to one where inflation is becoming a real threat, and growth is, at best, slowing.

The suddenness of the change in the economic landscape from goldilocks (not too hot – not too cold, with above trend growth and no increase in inflation) to stagflation (low growth accompanied by increasing inflation) goes beyond anything I can remember.

Until the start of last summer we were all singing praises to the wonders of globalisation. Emerging countries that embraced globalisation, in particular China, India and Brazil, were becoming an economic force to be reckoned with. Their development was creating an unbalanced demand for energy and base metals causing commodity prices to reach record levels in nominal terms.

Yet this increase in the price of energy and basic resources was not transmitting itself to inflationary impulses at the retail level of prices. The transfer of manufacturing activities to low cost emerging countries, particularly but not solely China, meant that in spite of higher input cost for the material and energy elements for manufacturing of consumables, the lower cost of labour and overheads more than compensated, meaning that the retail price of products on the shelves of the Walmarts and Tescos of this world was quite stable and quite often falling.

This globalisation process was on the other hand keeping in check the labour cost in developed countries given that the bargaining power of organised labour (unions) was weakened by the facility of employers to shift their shop to China et al if labour in the home country would get too expensive. This moderation in wage settlements was another reason for the benign consumer inflationary environment we have been having this century.

The low inflation readings were also aided by the methodology of measuring it. Central banks have a habit of reading inflation in two measures. The first is headline inflation which includes a wide spectrum of retail prices, including energy and food. But they mostly track and base their monetary policy decisions on the reading from the core measurement of inflation that eliminates from headline inflation the effect of price movements in food and energy on the pretext that these prices are too volatile to be addressed by monetary policy changes. By tracking the core inflation, central banks were not concerned about the immediate price movements caused by volatile energy and food but were mostly concerned to ensure that there is no transmission of second round inflation to the general price level of the economy.

It seems that suddenly the almost too good to be true economic scenario is falling apart. The obduracy of energy prices is forcing central banks to reconsider their neglect of headline inflation as it is becoming clear that high energy prices are not a passing phase and are unlikely to be compensated anytime soon by lower energy prices. Furthermore on top of stubbornly high energy prices, central banks must now take into account price rises of soft commodities, basic cereals like wheat, corn and barley, which could unleash a general price ripple increase in most food prices given that these cereals are not only irreplaceable ingredients for basic food products, as basic as our daily bread, but are also the basic ingredients for animal feed on which meat and dairy prices largely depend.

But it is not only a question of technical measurement of inflation. It is also that as China and India move up the development ladder their effect on inflation in the developed world is changing from benign to threatening. The costs of imports from these countries is increasing both as a result of rising domestic costs as well as a result of appreciation of their currency to reflect their enhanced economic status. Coming at a time when their internal development is continuing to make huge demands for energy, basic resources and soft commodities to feed an increasingly affluent consumer, high prices of energy and cereals mean that the inflation scenario in most developed countries is shifting.

Central banks would in normal circumstances have addressed such inflationary threats by tightening up their monetary policy, increase domestic interest rates to tame demand for imports and reducing cost pressures in the economy. The problem is central banks are currently having to fire-fight another more urgent problem caused by the sub-prime mortgage default problems in the US which demands lower not higher interest rates. Fighting inflation by tightening monetary policy will have to wait.

This gives rise to a serious risk of unmooring inflation expectations from their hitherto low levels. And it is well known that inflation expectations are self-fulfilling. Once consumers expect higher inflation this will realise itself as manufacturers and retailers gain pricing power and consumers demand higher wages to protect their real value.

This is the conundrum that will face unions in 2008 and beyond. Their benign wage demands so far were moored on low inflation expectations and higher value of their residential assets and financial investments. Workers were happy to moderate their wage demands if low inflation was helping to raise the value of their real estate and financial investments. The scenario is changing. Property prices worldwide are falling, financial investments are volatile, and expectations about inflation are worsening.

Can the unions keep their members’ trust if they persist in their benign wage settlements? And if unions become more demanding would this not force central banks to raise interest rates at a time when the economy needs looser monetary policy to cushion the external threats?

And if unions blow their top off and start demanding their full share, would this not give further impetus to inflation forcing employers to accelerate relocation to more friendly economic environment thus causing reversal in unemployment that has been steadily falling.

The conundrum that unions have to solve is whether they want to be flexibly part of the solution to restore goldilocks or whether they revert to their traditional narrow role and risk stagflation. The line between the two is very narrow but the economic outcome is widely different.

I wish my readers a peaceful Christmas full of the best things in life.