Our analysis of the link between oil prices and inflation in the 1970s and our comparison of that link with today yielded several conclusions. First, oil has far less of an impact on both inflation and the economy than it had 30 years ago. Second, the origin of current inflation is not oil per se. In fact, todayÆs inflation stems from the same phenomenon that caused oil prices û and other commodity prices û to rise. Third, while oil is not the cause of current inflation pressures, these pressures are not completely over yet, because the factor explaining both oil price increases and overall price increases hasnÆt disappeared. Our final conclusion relates to inflation protection: If an investor is only seeking protection from rising prices then investing in gold is certainly not the best he can do.
On April 24, 2006, oil prices hit the stunning mark of $75 per barrel. This was 660% higher than the low (below $10) in 1998, when the British magazine The Economist had ôThe end of oilö as a front-page title. Not only did oil rise by an astonishing 30% per annum on average since January 1999, but other commodities û copper (+24.5% p.a.), nickel (+24% p.a.), natural gas (+17% p.a.), silver (+11.5% p.a.) and even gold (+10% p.a.) û were also heralding a new age.
In the past, increasing oil (and commodity) prices have led to a sharp acceleration in inflation rates. The 300% surge of oil prices in 1974 resulted in peak inflation rates of more than 12% in the US, 23% in Japan, and 7.5% in Germany. The second oilshock surge of 165% in 1979 led to peak inflation rates of over 14% in the US, 8% in Japan, and 7.5% in Germany. So instead of worrying about inflation pressures, we should first consider why the current oil price increases (+140% in 2000 and another 50% in 2004) didnÆt hit inflation much harder (see Chart 1).
2006 is not 1976
Today is not comparable with the 1970s for at least three reasons. First and foremost, until recently the increase in oil prices was primarily driven by a strong swell in demand. With the pursuit of globalisation and the emergence and increasing economic importance of China and India, as well as Russia, Brazil, Mexico, Indonesia, and other countries with populations significantly above the 50 millionthreshold, world oil demand has dramatically escalated in the last few years. While a similar phenomenon occurred in the late 1960s and early 1970s when Japan and Western Europe became fierce competitors of the US, the sheer size of the human reservoir of the new ôbig countriesö lifts the demand side to an entirely new dimension. However, while demand was increasing in the 1970s the oil shock back then was not demanddriven. By cutting artificially, abruptly and significantly supply it was induced by OPEC. The dimensions of the oilprice increases in the last five years are comparable to the ones seen between 1973 and 1982. However, because these oil-price increases are the result of a free play of market forces û and not of a curtailment imposed unilaterally by a cartel û they are far less severe.
Secondly, the structure of the world economy has changed radically since the 1970s, when globalisation was not even a buzzword. National markets û even in the Western World û were still relatively protected and closed, allowing national companies, which werenÆt facing foreign competition, to pass through cost increases to the end-prices charged consumers. Today, such a practice is not even possible. Just a couple of years ago, every pundit was proclaiming the end of inflation, by acknowledging either the ôdigital deflationö rendered by the internet or the ôglobalisation phenomenonö, or both. Both the internet development, which reduces pricing power of firms and the globalisation phenomenon, which puts pressure on the labour costs are not over yet. In fact, what we are currently seeing is a race between commodity price increases and downward pressures on labour costs.
Finally, the importance of oil to the global economy is diminishing. In the largest (until recently) oil-consuming regions and countries û the US, the European Union and Japan ¼û the oil-to-GDP ratio has more than halved in the last 30 years. Similar evolutions can be observed in China, and to a lesser extent in other Asian countries like Korea or Thailand (see Chart 2). The catalysts are well known: more energy-efficient production and consumption, substitution of oil with other energy sources, and the evolution of the Western economies from industrial to services-based. Thus, the impact of the oil prices on inflation is far less dramatic today than in the 1970s.
But there is more.
Fueling inflation or cooling it down During the first two oil shocks, the US and Europe were confronted for the first time since the end of the Second World War with a real recession, i.e., a massive increase of unemployment. The reaction of governments and central banks (which were not independent as they are today but an integral part of the economic policy of the government) was to increase demand by increasing government spending and printing money. In hindsight, this type of ôKeynesianö economic policy only fuels inflation in the long run when it is applied to a supply-side shock such as an oil shock. And that is exactly what it did in the years after the first two oil shocks.
In 1973, the Bretton Woods system of fixed exchange rates collapsed, allowing the central banks to act on their own. Some of the banks, like the German Bundesbank and the Swiss National Bank, immediately gained their independence and focused on inflation-fighting. Other banks, like the Bank of England, the Banque de France, and the US Federal Reserve, waged war against a supply-induced recession with the consequence of double-digit inflation rates a few years later.
This was a painful lesson that reverberates today in the independence of most central banks and their clear mandate to contain inflation. If a central banker expresses concerns about the high oil prices, it is not because he fears a recession but because he fears inflation. Moreover, he might even go so far as to hike interest rates to avoid inflation even in the presence of rising oil prices û something quite unthinkable in the 1970s.
So, no fears of inflation?
Oil is currently not a reason to fear inflation, but the possibility of inflation pressures in the future should not be dismissed. A liquidity overhang has built up in the aftermath of the bursting of the stock market in 2000 and the subsequent policy of Asian central banks to maintain the dollar at artificial levels. In the last five years, i.e. since the bursting of the bubble, global liquidity has increased by almost 90%, compared with an historical five-year average rise of around 30% (see Chart 3). This liquidity buildup has not shown up yet in the prices of goods (as it would have done a couple of years ago). Given that central banks are now trying to reduce liquidity, it may never filter through to prices.
Another reason for the current lack of inflation pressures is, as mentioned above, the globalisation phenomenon, which keeps wages and labour costs under control. Nevertheless, the growing pool of liquidity has fueled increases in the prices of several asset classes, including real estate and commodities. So, the current climb of oil prices can be viewed as more than a signal of inflation pressures lying ahead; it is an early symptom û or an early warning sign û of the liquidity overhang.
The systematic increases of interest rates by the Fed since the mid-2004 were not a response to increasing oil prices, but an attempt to reabsorb the tremendous liquidity build up between 2001 and 2003. Is it finished? Almost any further Fed rate hikes would most likely start to hurt the US economy, which is already showing the first signs of weakening, especially in the housing market and in consumer sentiment. Moreover, the liquidity swell was a global (at least a US/Asian) characteristic of the last couple of years. Both China (with its new ôflexibleö exchange rate regime) and Japan (with the abandoning of quantitative easing and the possibility of rate hikes already this year) have also started to reabsorb liquidity. However, these countries are confronting other problems û a fragile banking sector and non-performing loans in China and an immense publicsector debt in Japan û that donÆt allow for a rapid and strong reaction. Thus, we expect to see more inflation worldwide in the forthcoming quarters.
Which protection?
Before looking at what an investor can do about inflation, we stress that current inflation expectations are in no way comparable to the ones seen in the 1970s. Even if global inflation worsens, itÆs unlikely to head toward the double-digits or even to the upper single-digits. Therefore, investors should consider the other important aspects of an asset class, not only its inflation-protecting capacities.
Whether inflation is expected or unexpected is also an important part of the investment decision. Asset classes usually react quite differently to these distinctions. While most assets will adapt in an inflationary environment to protect from expected inflation, they will not necessarily hedge unexpected inflation.
Moreover, when buying a specific asset, an investor is usually not only exposed to inflation risk but also to other types of risks (see Table 1). The table summarises the different characteristics of major asset classes. We examine the details of two of them: gold (and more generally commodities) and TIPS (US Treasury inflation-protected securities). While inflation protection is a nice by-product of gold, it is the main characteristic of TIPS. As a consequence, gold might protect against inflation in the long run, but its protecting capacities are far less secure in the short run. Although the real price of gold has not lost value in the last 200 years, neither has it gained value (see Chart 4).
The current gold frenzy is partly occasioned by investors with inflation fears and partly by international geopolitical risks. All in all, we do not recommend that investors buy gold for its inflation-protecting properties. In the long run, the real return (i.e. once adjusted for inflation) is nil and for a supposedly ôsafeö asset, the volatility is quite high.
A preferable alternative investment to protect against inflation is TIPS. However, some countries do not offer this type of government security. For example, just a few months ago, Germany started to offer an inflation-indexed government bond. Nevertheless, every major financial intermediary is apt to replicate via structured products different types of fixed income investments with inflation protection or indexing a fixed income structured product on a specific price indices. If an investor is really only looking for inflation-protection, we would clearly prefer the investments that are specifically build to address this issue, like TIPS, to investments for which inflation protection is only a loose by-product, like gold.
A little bit more inflation might be ahead, but we should definitely not worry. Despite the increase in oil prices, inflation has no chance of reaching the dimensions seen in the 1970s. In addition, both the central banks and the financial markets are well prepared. Central banks have learned a lesson from the past and are likely to keep inflation under a tight rein, while financial markets have created a host of investment instruments to protect investors from inflation.
The above article is reproduced from the Summer issue of Asian Private Capital, a supplement to FinanceAsia magazine.
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