Marcel Cassard, Deutsche's global head of fixed income and economics research, says that implied volatility for inflation markets in Europe is pricing in expectations that inflation will return to levels experienced in the 1970s. "They are, in other words, very rich," he said at a recent conference in Barcelona.
Asia is a different story, for three reasons. First, food and energy take up a much bigger share of the average person's living expenses. Second, unlike economies in the US and Europe, Asia is still growing. Third, to make matters worse, some Asian central banks have still not adjusted to the inflationary environment and continue to maintain a loose monetary policy that favours strong economic growth.
In its latest economic report out Tuesday, the Asian Development Bank called on the region's central banks to tighten policy, arguing that many emerging East Asian economies remain "behind the curve". The effects of inaction are plain to see in Vietnam, where headline inflation rose to more than 25% in May, the stockmarket has dropped 60% since the start of the year, and the currency is under intense pressure.
It is also becoming clear that inflation in Asia is not just about food and energy. Core inflation, which excludes both these categories, has now started to rise across the region, "indicating that a much more broad-based second-round effect may be underway", says the ADB report. This is most obvious in Singapore and the Philippines, where core inflation rose to 6.8% and 6.2% respectively in May from 3.5% and 2.6% in December 2007. In Indonesia, it reached 8.7% in May, up from 6.3% at the end of last year.
"The risk of inaction is rising, and the region's monetary authorities need to formulate more forceful and pre-emptive policy responses," says the report, citing China and Vietnam as countries that clearly need to tighten further. "Across the region, there are signs that insufficient policy responses have allowed cost-driven price increases to feed higher inflation expectations, thus threatening to trigger a vicious wage-price spiral. The balance of risks is clearly being tilted toward high inflation."
The inflation environment in the developed economies is quite different. Oil prices are certainly high today, but Cassard says the rising price of crude is partly the result of lower production by Saudi Arabia in 2007, which reduced its output in anticipation of lower economic growth and higher non-Opec production. Both assumptions turned out to be wrong, leading to a supply shortfall and explaining part of the subsequent price hike.
"This year is quite different," says Cassard. "Demand for oil will come down as consumption in the US and Europe falls, and Saudi Arabia will increase production. This will help redress the balance."
At the same time, countries that subsidise oil, such as China and India, are being pressured to cut their level of support, which should lead to a further slowing in demand growth as people start to change their behaviour and use less oil.
The story is similar with food prices. Almost every bank on the street is busy touting research that explains the fundamental drivers pushing food prices higher, from the growing preference for protein in the emerging markets to demand for biofuels in the West. These are all real phenomena, but none of them explain why prices have spiked so high, so quickly.
"The increase in meat consumption by emerging markets as incomes rise is true but it is a 20- to 50-year phenomenon," says Cassard. "You can't use it to explain a three-month phenomenon."
The recent price spikes are better explained by weather disruptions, he says, which means that it doesn't make sense to extrapolate the rising prices into the future, assuming that harvests will revert to average levels in the future. As with crude oil, there are long-term drivers of rising prices, but they are not the cause of today's spikes.
Finally, the recessionary environment in the US is not one where people are asking for higher wages or producers are asking for higher prices, which means that core inflation is not actually high. And the EU, says Cassard, is probably two quarters behind the US.
So, with core inflation in check and growth in oil and food prices not expected to maintain today's momentum, Cassard predicts that headline inflation in Europe and the US could be halved by the end of next year, if the price of oil were to stay at current levels. The outlook in Asia is much bleaker.
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