Starting from July and August, the subprime crisis spread through broader economy in the US. It led to huge volatility in the global financial markets and triggered worldwide credit crunch. Major central banks in Europe and the US injected billions of liquidity into the banking system and halted interest rate hike. The Federal Reserve even took a bold move to lower its discount rate and federal funds rate by 1% and 0.5% respectively in order to help forestall the adverse effects on the broader economy. Yet, whether global inflation could sustain its moderate pace remains a controversial issue, major central banks in the world might start tightening its monetary policy again once the economy as well as the housing, financial and credit markets returned its normal growing pace. This paper examines the issues of global inflation outlook.

Low Interest Rate Environment created Ample Liquidity

The re-acceleration of global inflation was mainly caused by the low interest rate policy adopted by the central banks around the world. In the beginning of 21st century, all major central banks cut their benchmark interest rates aggressively. The accommodative monetary environment lasted for several years. Additionally, the world economy registered robust growth, together with the rapid expansion in the two populous nations, China and India. The demand for raw materials and energy increased substantially, leading to higher oil and agricultural prices.

Under the shadow of Asian Financial Crisis, technology bubble, 9.11 incidents and global economic recession, the primary concern of the central banks was deflation. Therefore, major central banks around the globe adopted accommodative interest rate policy and cut rates aggressively. However, when the global economy recovered since 2004, the central banks did not promptly raise rates back to neutral level, but raise rates at measured pace only. For instance, the Federal Reserve cut its federal funds rate to 1%, the lowest level since 1958. A long period of low interest rate provided ample liquidity to the financial markets and real economies.

Since the economic recovery, the central banks only raised rates at a measured pace. The market and investors expected the continuation of low interest rate environment. They became bullish about the real estate, commodities and equity markets performance, leading to strong run in nearly all asset markets. As a result, even the central banks raised rates by a quarter percentage point, its effect was offset by the investors' bullish expectation. Investors were still willing to borrow for investment. This explained why the financial markets are still flooded with ample liquidity, even the central banks raised rates continuously.

Whereas the markets are flooded with liquidity, the financial and real assets can be boosted up easily, leading to a strong bull market. Strong asset markets in turn reassured the buoyed real economy. High asset prices can stimulate both consumption and investment. For example, real estate developers would speed up their construction progress when the property prices rose. Higher equity and property markets generate huge wealth effects to the households and the economy which would then stimulate consumption, support corporate earning growth, and lead to higher consumer prices. As a result, the strong real economy, financial and asset markets performance would finally drive up consumer prices.

In order to curb the inflationary pressure, the foremost task of policymakers is to tackle the problem of liquidity. The effectiveness in controlling liquidity by central banks depends very much on their decisions to raise rate promptly and boldly, as well as demonstrating their strong determination to do so. Bullish expectation on financial and real asset markets can only be reversed by such prompt actions taken by the central banks. Investors might doubt whether their higher asset prices are able to offset the negative effect of rate hike. Loan demand would shrink and be able to curb the price pressure of subsequently.

Currently, the subprime crisis has led to huge volatility in the financial markets and worldwide credit crunch. Central banks halted rate hike. The Federal Reserve even cut rates to forestall the negative effect to the economy. On the other hand, the accommodative environment would inevitably curtail the policy effectiveness in fighting against inflation. The problem of ample liquidity might be sustained, leading to a strong run in financial and asset markets. Inflationary pressure might build up again.

Skyrocketed Demand for Energy and Commodities stimulate Inflationary Pressure

Since the global economic recovery in 2004, the world economy grew solidly. However, the US growth has been dragged by the housing market correction and subprime crisis, the full year growth rate might slow to 2% or below, noticeably down from the above 3% level in the past few years. Nevertheless, the International Monetary Fund (IMF) estimated that the global economy will remain solid, in spite of downturn in the US economy. IMF revised the 2007 and 2008 global growth target upward from 4.9% to 5.2%, thanks to the lowered reliance to the US economy. Also, the growth momentum in the developing countries, like China, India and Russia, are still very well. The IMF upwardly revised their economic forecast by 1.2, 0.6 and 0.6 percentage point to 11.2%, 9.0% and 7.0% respectively. The emerging countries now become the growth engine of the world economy.

Like other commodities, the demand for energy and raw materials also grow alongside with the solid growth of the global economy, especially when the two most populous nations, China and India, are rapidly urbanizing. Investment in manufacturing and real estate industries remain high. The living standards of millions of Chinese and Indians will continue to improve, leading to the rise of middle class. The per-capita demand for energy and raw materials will rise continuously, driving their prices higher. In addition, energy supplies were disrupted by geo-political issues and hurricanes. The rapid development of investment and derivatives also take a role in fuelling commodities and energy prices higher. Energy prices rose three-fold from around US$20 a barrel in 2001 and 2002 to hit a historical high of over US$80 now. The RJ/CRB Index, which tracks a bundle of commodities prices, also increased sharply from 180 to 190 in 2001 to 320 currently. In the developed countries, service industry becomes their pillar industry and their reliance on energy and raw materials has reduced considerably. Their core inflations remain subdued. Nonetheless, the developing countries and the world as a whole still face inflationary threat.

Until recently, the market expects the subprime crisis and financial market volatility would not pose a greater threat to the global economy. However, the interest rate cut would affect the performance of the US dollar. Investors might still prefer investing in commodities, supporting the performance of energy, raw material and agricultural products.

High commodity prices are not only confined to energy sector, the precious metals, raw materials as well as agricultural prices all raced up notably in recent years. Corn and wheat prices have already doubled since 2005, which lifted up food and consumer prices around the globe. The higher food prices were stemmed from stubbornly high energy prices. Major countries are actively developing renewable energy amid high oil prices. The demand for corn and wheat skyrocketed as they are the major materials for developing renewable fuel. Higher corn prices also drive up feed prices and eventually, adding pressure on the pork prices. Obviously, the impact of higher energy prices has already spread to food and other consumer goods prices.

China's Low Cost Era would pass gradually, its Short-term Effects remain limited

Over the past one or two decades, China has supplied hundred millions of low-skill labour to the world economy. China did not have comprehensive regulations in relation to environmental protection, conservation, pollution, and energy wastage. The RMB was pegged with the US dollar before its reform in 2005. All those factors contributed to the huge cost advantages of China. Large amount of Chinese products are exported to the western countries and helps control the inflationary pressure in the western world. The global inflation is still well contained even the energy prices hit fresh record.

After all, China's low cost era would pass gradually. After 20 more years of rapid development, income in urban and rural China all grew substantially. Even tenth of millions farmers will join the urban workforce each year, the adoption of one-child policy in China in the past 30 years will eventually drag down the new labour supply in the coming few years. Furthermore, China has already realized the environment has borne huge social cost amid rapid economic growth. More comprehensive regulations on environmental protection, pollution and energy wastage will be enacted in the future. The manufacturing cost will be increased undoubtedly. Recently, a large amount of toys produced in China did not meet the safety standards in the US, which led to sizable product recall. The manufacturers in China suffered huge losses. It is expected that the manufacturers will strive for better product quality in order to meet all the safety, environment and energy standards. Together with the pressure from rising labour cost and RMB appreciation, the low cost era might pass gradually, fuelling global inflationary pressure.

Some expected that manufacturers can move to other low-cost regions, like Vietnam, if the cost advantage in China receded. Compared with China, the scale of other developing countries are relatively small. They are not large enough to replace China in providing huge amount of low-cost labour. India is another populous country, but they focus on developing service industry. Their manufacturing industries, especially labour intensive light industries, and their infrastructure facilities still lagged far beyond China. Therefore, India is not able to replace China to be the world factory in the future.

Nevertheless, the labour and land costs in China are still far below the level of western developed countries. Whilst China strives to improve their product quality, the cost advantage should remain prominent despite rising costs. The low-cost advantage would pass only gradually, without posting significant inflationary pressure to the world economy in the short-term.

All in all, the accommodative interest rate environment led to the problem of ample liquidity. The problem still not yet resolved. The global economy continues to grow solidly which leads to higher demand and prices for energy, raw materials and agricultural products, adding inflationary pressure globally. Additionally, China's low cost era would pass gradually. Its effect on global inflation will be surfaced in more distant future. To minimize the adverse effect to the economy, the central banks need to promptly adopt tightening monetary policy before the inflation expectation is formed.

Choi Wing Hung
Economist