Asia Pacific: Should Central Banks Fight Stagflation Now?
Andy Xie (Hong Kong)
Asia is showing symptoms of stagflation. While the economies are decelerating quickly, inflation rates are picking up virtually everywhere. Should Asian central banks take stagflation seriously? We think so.
First, interest rates are just too low. The current negative real interest rates are causing excessive demand for property. The distortion in resource allocation compounds over time and may eventually trigger another global financial crisis. Thus, even if inflation does not last, it is increasing financial risks to the global economy.
Second, the cost push-led inflation could mutate into a wage-price spiral. This risk is especially acute for Korea. Its strong labor unions are likely to demand higher wages if inflation remains high. This risk is perhaps lower in countries that do not have strong unions.
[I think he misses the boat in general on this point. Korea is the exception not the rule, I see little chance of this in the US or Japan or China - Mish]
Third, if there is a major supply shock due to Middle East turmoil, the mild stagflation that we are currently experiencing could turn virulent. Asian central banks could be trapped into accommodating the higher oil price, as the Fed was in the 1970s.
[no question about this but way does he say Asian CBs as opposed to ALL CBs - mish]
The resulting weakness in currencies could perpetuate inflation.
However, Asian central banks appear poised to accept higher inflation, at least for a period, without raising interest rates, even as the Fed is normalizing the US interest rate. Korea and Taiwan, in particular, may not raise interest rates for the next four to six quarters as their central banks focus on weak domestic demand. China may take action before the end of the year but would likely raise interest rates by half as much as the Fed does. The stagflation scenario ahead would cause Asian bonds and currencies to weaken.
Stagflation is stalking the world. Governments and private forecasters are lowering GDP projections but raising those for inflation. China’s inflation has accelerated to about 5% from mild deflation in 2002. Korea’s inflation is at 3.6% now, up from 3% a year ago. The US inflation has also picked up by one percentage point to 3% from a year ago. Even the Euro zone’s inflation has risen by half a percentage point to 2.2% in a year.
In terms of GDP growth, the US was at about 4% in 1H04 versus 6% in 2H03 and will at best deliver the same in 2H04, we estimate. The Chinese economy is beginning to decelerate, and the pace of deceleration may quicken in 2H04. Korea’s domestic demand is still falling. Only Europe is improving a bit.
The overall economic trend is diverging from the inflationary trend. As inflation is a lagging indicator, this sort of divergence happens in a typical cycle. When a central bank normalizes interest rates, inflation generally decelerates and the GDP growth rate normalizes after a period of above-trend growth during the initial cyclical recovery.
The difference this time is that the growth surge was intense and concentrated because monetary stimulus led to a global property bubble and a Chinese capex bubble.
[While the above is true there is another BIG DIFFERENCE: Another big difference this time is where interest rates are currently. There is next to no room to cut and one pissy little hike with the threat of more has already slowed things considerably. Furthermore the FED is so far behind the curve on this that they are finally hiking just as all sort of other stimulus is wearing off. A double whammy. Mish]
The former prompted consumers in Anglo-Saxon economies to spend feverishly; the latter caused commodity prices to skyrocket, lifting Asian manufacturing economies and commodity-based economies elsewhere.
Bubble-induced growth can reverse quickly. The Chinese government deliberately popped the bubble, fearing a financial catastrophe if the bubble remained unchecked. The Chinese economy is now cooling; sales of auto and property are slowing and production is beginning to ease. Production is likely to slow more quickly in coming months as inventories rise under sluggish sales.
China’s slowdown is affecting Asian manufacturing economies initially, as the demand for equipment and components is the first to slow. As production slows further, demand for raw materials could decline and raw material-based economies would be affected next. Just when higher raw material costs are being passed on to the CPI, these economies are beginning to slow sharply. This is why stagflation appears a realistic scenario for in Asia.
Consumer-led economies tend to decelerate more slowly than production or commodity-based economies. Their property markets generally remain resilient as real interest rates stay very low and normal interest rates rise slowly.
[That is an interesting idea. Any thoughts? mish]
Furthermore, China’s slowdown would benefit consumers as commodity prices decline. However, these economies are still slowing more quickly than in a normal cycle. When property prices stop rising, consumption decelerates quickly. So, there is a feel of stagflation in these economies too.
Should Central Banks Worry About Stagflation?
There is a good case for structural deflationary forces to remain (see our “Today’s Inflation May Lead to Tomorrow’s Deflation,” dated April 14, 2004). Hence, one could argue that central banks could wait until a cooling global economy brings down commodity prices and inflationary pressure passes. This approach is dangerous, in my view, because it does not address the risks that would magnify the cost of high inflation today.
First, negative real interest rates are causing massive distortions of resource allocation, which could lead to financial crises. Major central banks set out to fight deflation with monetary stimulus three years ago. Instead, the excessively low interest rates triggered a global property bubble and a capex bubble in China. Both caused the prices of raw materials to skyrocket. The current cost-push inflation is the echo from asset bubbles around the world.
Not to deal with inflation is not to deal with asset bubbles. Prolonged asset bubbles will eventually lead to financial crises.
This risk is especially high in China and the US – the two economies that led the global economy in this cycle. The buoyant asset markets have sustained the US consumption boom, causing its trade balance to deteriorate further despite the dollar weakness. The endgame for the US is either a property crash or a dollar crash.
[The endgame for the US is a property crash or a US$ crash... what about both? Neither? thoughts - mish]
The earlier the Fed tightens, the smaller the crash is likely to be. The Fed is raising interest rates now. It would be a mistake if it stops when the economy slows. Now is the time to rein in the systemic risk by raising interest rates.
[Aren't we more than a bit late with stimulus arlready wearing off - mish]
China’s financial institutions’ loans to the non-financial sector increased by 45% between December 2002 and May 2004, rising twice as fast as in the preceding 29 months. China has been experiencing a credit bubble with all its attendant symptoms – negative real interest rate, rapid growth of the property sector, energy shortages, and high commodity prices. The consequence of the bubble is another pile of bad debts. The longer the bubble lasts, the more bad debts China will suffer.
The Chinese government has tightened credit and its land policy to cool investment. The economy is beginning to decelerate. However, the quantity approach to credit tightening has led to a black market that distributes credit at much higher interest rates. China is targeting interest rates, money supply, and the exchange rate. It is very hard to accomplish this and it could result in the creation of black markets. It would be much better for China to raise interest rates and make this consistent with credit policy.
Exhibit 1
[There is an exhibit in the article if you look it up - not all that significant - mish]
Second, in economies with strong labor unions, cost push-induced inflation could turn into a wage-price spiral. In Asia, Korea is particularly vulnerable to this risk. As inflation pressure continues, labor becomes anxious about losing purchasing power and demands wage increases. Korea has seen a number of such incidents. Hence, central banks should pay close attention to the risk that strong labor unions pose.
I believe that Korea should raise interest rates soon to convince labor not to push hard for wage increases. However, Korea is unlikely to adopt such a stance. Instead, weakness in domestic demand drives policy-making. It is possible that inflation pressure will blow over, and some excess in wage growth would, therefore, not harm the economy. But, the risk of persistent stagflation in Korea is significant, in my view.
Third, if central banks do not deal with inflation now because of growth concerns, another oil shock may force them to accommodate more inflation. This would bring back the experience of the 1970s. This risk may not be very high. As the global economy slows, the oil price should come down (see "Oil Price May Fall Sharply,” May 23, 2004). However, central banking is about risk management. Interest rates are already too low and the Middle East is unstable. Central banks should build up some safety margin now by raising interest rates, even though it may speed up the economic deceleration.
Prudent Central Banking Is Unlikely to Prevail
Politics around the world increasingly is a focus on growth. China is the only country that acknowledges that it is growing too fast. Even robust economies like the US still desire more growth. High leverage, I believe, is the reason. Global indebtedness is at an unprecedented high because the world has experienced several bubbles in the past two decades without a thorough shakeout.
[No completed shakeout is right - mish]
The debt could be with the government, household, or business. Hence, politics actually favors stagflation, especially for economies with short-term debt (see “Could Stagflation Save Asia,” October 13, 2003), which would redistribute wealth from savers to borrowers.
Central banking is at a crossroads, in my view. The belief that monetary policy can smooth economic cycles led us down the path of asset bubbles. It also encouraged governments not to reform their economies structurally, looking for monetary bailouts instead. If central banks do not tackle inflation now, the world may be headed for the biggest redistribution of wealth in history through stagflation.
morganstanley.com
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Quite an interesting Article.
Thoughts Anyone?
Mish |
