Global inflation: Not yet a worry for most policymakers Global Economic Outlook, Q2 2017

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Inflation around the world is edging up, but is it time for central banks to lose sleep over it? Not yet, according to our analysis. While Japan and the Eurozone are not out of the deflationary woods yet, key Asian economies have to worry more about household debt than inflation.

Introduction

Brave, nay foolhardy, is the central banker who does not lose sleep over inflation. History is replete with instances when even minor miscalculations about inflation and inflation expectations have pushed central banks off the rate curve, thereby raising complications for economies. It is not surprising, then, that as prices go up in key developed economies, analysts are turning their gaze to price trends (figure 1). In the United States, for example, consumer inflation—both headline and core—is above 2.0 percent.1 In the Eurozone, deflationary pressures are easing, while in key emerging economies in Asia, prices are edging up slightly this year after a stretch of stability. So is the current bout of price rises worrying? Despite higher inflation numbers, we believe that it is still too early to worry about inflation.

Headline inflation has been moving up in key developed economies

Energy prices appear to be weakening of late

A quick look at inflation dynamics around the world suggests that while headline inflation has gone up, core inflation, which excludes volatile food and energy prices, remains steady. Instead, noncore elements—primarily energy—have pushed up consumer prices over the past few months. In the Eurozone, for example, year-over-year growth in the harmonized index of consumer prices excluding fresh food and energy is still below 1.0 percent; in fact, growth fell in March to 0.7 percent from 0.9 percent in February (figure 1). In Japan, consumer prices except food and energy fell in February (-0.1 percent). In emerging economies such as China, India, and Indonesia, it is yet again energy prices that have put upward pressure on headline inflation (figure 2). Even in the United States, where headline inflation went up to 2.7 percent in February, core inflation, including core personal consumption expenditure (PCE) inflation, has more or less held steady over the past year.2

Energy-related inflation has been pushing up headline inflation

Energy prices, however, have slowed this year. Brent prices, for example, are down by 1.4 percent this year (until April 10) after rising 50.9 percent in 2016. Prices are not likely to rebound sharply soon, given the increasing output in the United States—total weekly field production in the country started picking up in October 2016 and has gone up by about 9.0 percent since then.3 When prices rose sharply in 2016 relative to the previous year, shale once again made a comeback, with investments in the sector rising in Q4 2016.4 This has, in turn, partially negated the impact of the deal between major oil producers (excluding the United States) to restrict output. With energy prices weakening, their impact on headline inflation will likely decline, thereby thwarting the recent upward move in consumer prices.

A quick look at inflation dynamics around the world suggests that while headline inflation has gone up, core inflation, which excludes volatile food and energy prices, remains steady.

Aggregate demand not yet a major threat

In the Eurozone, GDP growth, at 1.7 percent, in 2016 was lower than in 2015 and is also below the average 2.2 percent annual growth recorded between 2000 and 2007. Similarly, in Japan, aggregate demand is yet to play a major role in pushing up consumer prices despite loose monetary policy, including quantitative easing and negative interest rates. While the United States has fared better than the Eurozone and Japan, earnings growth is still weak despite record-low unemployment. Average real weekly earnings, for example, grew just 1.0 percent in 2016 and fell in January this year, before recovering marginally in February (figure 3).5 With labor force participation low relative to the pre-recession period, it is likely that any push in earnings may be countered by a possible increase in participation, thereby offsetting some of the impact of rising earnings on consumer prices. The only major economy where aggregate demand is impacting inflation, although negatively, is Brazil. A prolonged period of economic contraction (-3.6 percent in 2016 and -3.8 percent in 2015) has been a key factor behind slowing consumer price growth in the country.6

Real earnings have not grown fast in the United States

Inflation remains below target range

The important thing is that even though inflation has been heading up in key developed economies, it continues to be below key central banks’ target ranges. For both the European Central Bank (ECB) and the Bank of Japan (BOJ), the upper limit of the target range for inflation is 2.0 percent, and the data show inflation is far from the range, especially for the BOJ.7 In the United States, where headline inflation is currently above 2.0 percent, core PCE inflation—the Federal Reserve’s (Fed’s) preferred inflation measure—at 1.8 percent, is still below the Fed’s 2.0 percent target. The story is the same for countries such as China, India, and Indonesia.8 Even in Russia and Brazil—two economies that have suffered high inflation in recent years—growth in consumer prices have been heading down in recent months and are currently closing in on their respective central banks’ targets (figure 4).

Even though inflation has been heading up in key developed economies, it continues to be below key central banks’ target ranges.

Brazil and Russia appear to have recovered from the high-inflation years

Household debt a bigger worry than inflation in Asia

In key economies in Asia, the focus is less on overall consumer prices and more on high household debt and house prices. Household debt in many Asian economies has soared since 2008, with debt-to-disposable personal income in economies such as Thailand and Malaysia higher than the level in the United States just before the Great Recession began (figure 5). A key contributor to high household debt in the region has been soaring house prices, which have also queered the pitch for central bankers in these economies.9 With the housing cycle intricately linked to financial stability, authorities are focusing more on countering bubbles in the housing market than on inflation. And instead of interest rates—the favorite tool to counter inflation—central banks are deploying a raft of macroprudential measures such as restrictions on second mortgages and loan-to-value ratios.10 Economies such as India are also focusing on affordable housing and lower borrowing costs for builders, which, authorities hope, will then be passed on to buyers.11

Asian households have piled on debt in recent years

Markets have priced in Fed rate hikes

For emerging economies across the world, currencies were a worry last year, as speculation increased about the Fed’s possible interest rate path. This, in turn, was a worry for consumer prices due to the threat of imported inflation. However, the Fed’s interest rate path has become clearer in recent weeks—markets have priced in three hikes in the federal funds rate this year, and a fourth hike is also likely.12 This has eased the pressure on emerging-market currencies. For example, the Brazilian real, the Indian rupee, and the Indonesian rupiah have stabilized this year (figure 6). In China, authorities, through a raft of measures, have for now been able to stem the decline in portfolio capital inflows into the economy, although portfolio outflows continue to increase. For example, portfolio investment into China fell from $969.0 billion in Q2 2015 to $734.2 billion a year later, before recovering since then.13

Emerging-market currencies have cut losses against the US dollar and moved up in 2017

No surprises likely from major central banks

With currencies stabilizing in emerging markets, energy prices slowing, and inflation still under control in major developed economies, interest rates are likely to have a steady path ahead in major economies. In Brazil, for example, lower inflation and efforts to stem the high fiscal deficit imply that the central bank is likely to stick to a rate-cutting path this year.14 In the United States, in the absence of unlikely shocks, the Fed is expected to raise rates by a total of 75 basis points this year. In Japan and the Eurozone, any decision to change monetary policy is unlikely, given continued weakness in their economies and below-target inflation.

Within the Eurozone, rising inflation will be viewed by the ECB as a positive development, especially in debt-laden countries. In Greece, for example, where inflation has risen above 1.0 percent this year—for the first time since August 2012—rising consumer prices, if sustained, will push up nominal GDP, thereby reducing the debt burden as a share of nominal GDP. The ECB will be in no mood to stem this momentum. The same is true for the BOJ, although its focus would be a permanent shift away from deflationary pressures.