Two very different inflation problems

February 21, 2011

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

There was more evidence in February that the world economy is re-flating; both China and the UK released inflation data that showed prices running above 4 percent. Authorities in these economies have a difficult few months ahead, if prices continue to rise at this clip then they may have an economic crisis on their hands.

Although the root causes of inflation in China and the UK are fairly similar – rising commodity prices combined with weak currencies – the treatment for both countries couldn’t be more dissimilar. China has to tackle its problem with rate increases and currency appreciation, whereas in the UK a rate rise could seriously hinder the economic recovery.

Taking a step back, inflation always had to rise in China if its economy was to shift to a domestic consumption model and the global economy was to stand any chance of effectively rebalancing. Thus, it could be argued that commodity price increases came at the right time for China’s economic growth story as it put pressure on employers to hike wages. The price of food and energy hit Chinese consumers  faster than they do consumers in the west because of the larger proportion of food in the Chinese basket of goods used to measure price changes (even though the food component was reduced in January, it was only reduced by 2 percent and remains high relative to western economies). Workers need prices to rise, and they need to rise at more than 5 percent a year to give the average Chinese enough money in their pocket to spend on discretionary items.

Pay packets have been increasing in China for the last 5 or 6 years, but they picked up extremely strongly in 2010 (just as commodity prices started to take off). According to some anecdotal data wages in the professional and financial services sectors are now rising at a 16 percent annual clip.

While that is extreme, the general trend towards higher wages is good news. Inflation is driving wage gains, which have been the missing ingredient from the Chinese growth mix. Wages need to rise in China to unleash a tsunami of domestic demand that, if all goes to plan, will help reduce China’s massive surplus and the US’s massive deficit and protect the future of the global economy.

But while some wage inflation is good, too much could cause employers to cut staff, pushing up unemployment and actually weakening consumption. In order to avoid this situation, action is required by the People’s Bank of China (PBOC) to stop an inflationary spiral getting out of control. Although the PBOC has raised interest rates 3 times since October, it needs to hike further to reduce the chances of the economy overheating.

In contrast, the Monetary Policy Committee at the Bank of England needs to avoid the temptation of hiking too much. The economic recovery is at an extremely delicate stage: the labour market is still deteriorating and public spending cuts have yet to take hold in a meaningful way. The Bank of England revised down its growth forecast, while revising up its inflation outlook at its February Inflation Report. While in normal economic circumstances that would suggest stagflation, in the UK inflation is forecast to fall off quite quickly. That is because temporary factors are keeping prices high: a hike in the national sales tax at the start of 2011, a 25 per cent drop in sterling in 2008-2009 and rising energy prices. However, inflation is essentially a rate of change, thus as long as the sales tax doesn’t keep rising each year, and commodity prices don’t increase by 30 per cent annually (as they did in 2010) then price increases should fall out of the index and year-on-year rates of inflation should start to fall.

The UK doesn’t have wage inflation either – wages are running at about 2 per cent, which is important for the UK to gain competitiveness and boost exports as a major driver of growth in the coming years. Thus, if the Bank was to raise rates now it would hurt businesses like manufacturers who are only just getting back on their feet after the global recession. A hike would also put upward pressure on sterling, making UK exports less attractive on the global marketplace.

So, two central banks with two very different inflation problems. But one thing that the PBOC and the BOE share is a tightrope – neither Bank can risk a policy mistake or the consequences could be huge.

Comments

Intersting article! Food for thought – that these two economies share similar inflation vs. growth issues!

Posted by Mazza66 | Report as abusive
 

Very interesting reading.

Posted by JeffAMA | Report as abusive
 
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