5 ways inflation is defining the 2014 economy

5 ways inflation is defining the 2014 economy
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Inflation, or lack thereof, is an important global economic indicator. Whether it is Sweden or Brazil, central bankers or policymakers, here’s a look at why inflation is so influential.

1. Europe, Japan, and repeating history?

Japanese Prime Minister Shinzo Abe could not have been more clear about his goals upon taking office in December 2012: Stop deflation to restart the Japanese economy. After a year of aggressive quantitative easing from Haruhiko Kuroda’s Bank of Japan, Japan finally posted positive inflation in June 2013.

Inflation has continued into 2014, although it has dipped for two straight months. After being trapped in a deflationary spiral for much of the last decade, Japan’s reflation is a monumental achievement. Abe and Kuroda are not in the clear yet, however. Much of the positive trend in inflation has been fuelled by soaring energy prices, which slowed from 9.9% growth to 1.4% in June.

Japan’s troubled economy should serve as a cautionary tale for the dangers of deflation to members of the Eurozone. Spain, Portugal, Greece, Bulgaria, Cyprus, and Sweden have all dipped into deflation in the last four months. Although Sweden and Spain have been able to emerge from falling prices, the deflation and low inflation environment in Europe is perpetuating the weak demand environment that has stalled the European recovery. Although Germany may be staying afloat (at least until recently), the situation is much worse in the rest of Europe.

2. The divide over inflation at the Fed

Uncertainty over when the Federal Reserve will raise interest rates from near-zero levels for the first time since 2008 has increased in the last six months as US economic data gradually improves. The doves have put more emphasis on the weaknesses seen in the labor market and GDP data, while the hawks have publicly worried about approaching the natural unemployment rate and the impending spike in inflation.

Inflation in June hit an annual rate of 2.07%, which is just the second month since 2012 that met the Fed target of 2%. The doves, led by Chairwoman Yellen, are cautiously more willing to let inflation settle at a slightly higher level in the short-term to put pressure on labor markets and wages. The clash between hawks and doves, however, is giving mixed signals to investors. Although the FOMC has been clear in its target of mid-2015 to raise rates, markets cause themselves anxiety over whether any new data point will change that path.

Eurozone deflation

Inflation remains weak throughout the Eurozone. Source: Eurostat

 

3. ‘Inflation truthers’ are getting louder

Even while inflation in Europe, Japan, and the US lags below their central banks’ target rates, an enthusiastic but small group believes inflation is actually much higher in the US. Led by internet communities like Zero Hedge and Shadow Stats, the belief that the US government is cooking the books on inflation is becoming more loudly expressed.

These theories usually point to rising food and fuel costs, as well as changes in how the Bureau of Labor Statistics calculates inflation, as evidence for their views. Never mind that prices of many other goods have been consistently falling, or that central banks follow inflation excluding food and fuel to avoid overreacting to volatile and exogenous changes in their prices.

The inflation truther story is beginning to permeate mainstream policymaking, threatening the Fed’s independence. Citing concerns that the Fed is keeping interest rates too low, which will lead to higher inflation, House Republicans have introduced a bill that would force the Fed to set interest rates based on a formal rule. The rule would be similar to the Taylor Rule that economist John Taylor designed in the early 1990s.

Many economists, including Chairwoman Yellen herself, oppose the bill because it impedes the independence of the Fed. Without this independence, they argue, it is impossible for the Fed to react to the crisis. Given that the claims of inflation truthers are rebuked nearly universally by economists, evidence remains scant that the Fed has lost legitimacy to act independently.

4. Wage growth remains low

The long period of low inflation in Europe and the US, at the same time that the Fed and ECB have kept monetary policy historically loose, has led many commentators to predict that uncomfortably high inflation is just around the corner. Despite these predictions being wrong time and again, the same commentators keep making them. Among the reasons their warnings have not come true is that wages haven’t grown much since 2008.

A leading indicator of future inflation is wage growth. As wages increase, consumers spend more and prices begin to rise. In the US, however, wages have remained nearly stagnate. Wage growth is lower now than at any time since the 1980s, according to analysis by Jared Bernstein.

Annual median wage growth

Annual median wage growth has decelerated since the 1980s. Source: Jared Bernstein

With wages and consumer prices both rising at about 2% annual rate since 2011, wage growth has not put upward pressure on inflation. Until it does, the Fed’s historically low interest rates are unlikely to cause the high inflation so many have been predicting.

5. Emerging market inflation and instability

High inflation is widespread in emerging and frontier markets. For example, Venezuela’s inflation is above 50% in light of dwindling foreign reserves, but the high inflation has had a bigger international impact in Argentina and Brazil.

Before news on Argentina turned to the fallout from its 2001 bankruptcy, its falsely-reported inflation and capital controls were front and center. Price controls and heavy taxes on certain imports have fuelled inflation of 25% in 2013, but official reports only reported 10%. New calculation methods announced in January were supposed to create more credibility, but have not so far. Hyperinflation has stagnated Argentina’s economy, putting the country into even worse shape for its credit showdown with bondholders in the US.

In Brazil, the combination of high inflation and outrage over World Cup spending caused months of civil unrest leading up to the tournament in June. When urban prices were rising at 6% per month and Brazil’s economy only growing at 2% per year in 2013, emotions spilled over in response to a hike in Rio’s bus prices.

The predicament of Brazil, like many other emerging markets, is the combination of rising prices and high inequality. With ineffective central banks, the situations spiral out of control and hurt the growth potential. With the World Cup ending in disappointment for Brazilians, the focus will return to President Dilma’s dilemma: how to curb inflation and kickstart a middling economy.

Categories: Economics, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.