In theory, a weakening global economy should cool demand and restrain the record-high oil and food prices that have raised the spectre of 1970s-style stagflation.
In practice, shackling price pressures may not be that simple. The recent spike that has pushed inflation to at least a 10-year high in Japan, the United States and parts of Europe came despite clear signs of a slowing economy.
Even as steep commodity prices lift costs for bread, petrol, clothing and airline tickets, there are opposite forces at work, too. The free-falling US housing market is deflating homeowners’ wealth. The subsequent credit contraction has constrained the flow of cash, curbing spending.
So is the world economy caught in the clutches of an inflationary spiral or a deflationary downturn?
The European Central Bank will have to weigh that debate on Thursday when it decides whether to join the US Federal Reserve, Bank of England and Bank of Canada in lowering interest rates.
All 72 economists polled by Reuters last week thought the ECB would stay on hold for a ninth consecutive month as inflation pressures persist.
The BoE is also expected to hold steady when it meets on Thursday.
Fed Chairman Ben Bernanke insists inflation will ease later this year, even if oil remains around $100 per barrel.
“Oil prices don’t have to come down to reduce inflation pressure. They just have to flatten out,” Bernanke said in his twice-yearly testimony to the US Congress last week.
Many on Wall Street concur. They expect the US Central Bank to cut interest rates again in mid-March. But John Taylor, the Stanford University economist known for developing a formula for setting monetary policy based on balancing levels of inflation and growth, worries that the Fed may have lowered rates too far already.
Further cuts risk stoking inflation, and perhaps a mild rerun of dreaded stagflation, he told Reuters last week. “The question is, are we at the beginning of one of those periods like we had in the 1970s? I’m hoping it’s not,” he said.
The primary cause of high food and energy prices is demand from fast-growing emerging economies like China, along with the rise of ethanol, which is gobbling up a big chunk of the US corn crop and diverting acreage from wheat.
Ironically, another reason may be investors seeking a safe haven from inflation. Commodities are normally considered a good investment in times of rising prices, but as more investors pour money into commodities, it boosts inflation. Some analysts are calling it an “inflation bubble”.
A dose of bad economic news may be just what Bernanke and his central bank counterparts need to support their view that slowing growth will eventually ease inflation. The Fed will pay particularly close attention to Friday’s US February employment report for clues on whether wage pressures are building.
There is already evidence of accumulating slack in several of the world’s leading economies. In the US, inventories of durable goods climbed to $322.3bn in January, the highest on record, as big-ticket purchases slowed. Britain’s fourth-quarter economic growth was inflated by inventories, up by the biggest amount in 20 years.
Fuel consumption appears to be waning as pricey oil takes its toll.
Still, January’s US inflation reports were not pretty. At both the consumer and wholesale level, inflation was considerably higher than economists had expected. Companies straining to keep up with food and fuel inflation are increasingly passing along the higher costs to consumers.
UBS analysts argue that many companies test out price increases at the beginning of the year, which lifts January inflation gauges, only to reverse course when demand fades.
But if that does not pan out, central bankers may be having bad 1970s flashbacks. (Reuters)