Global Inflationary Pressures: No End in Sight

Inflationary pressures, coming at a time when there are palpable signs of economic slowdown, have been spooking the global governments, policymakers, financial authorities and marketmen alike.

Worldwide, prices of commodities like crude oil, wheat and rice have skyrocketed in the last year or so. Policymakers have been finding themselves especially helpless in the present situation due to the "global" nature of the current inflation. Central bankers are also in a fix as, given the slowdown in economic activity, they won't be able to fight the inflation the way Volcker did by aggresively rasing the interest rates back in 1970s. Stagflation is extremely difficult for conventional policy instruments to deal with since any attempt to deal with one of the problems tends to exacerbate the others.

Things are pretty difficult this time as the price of crude oil, which is supposed to have a ripple effect on prices of almost everything concerning our life, is seen as stoking the inflation. The spike in oil prices, which hit $139 per barrel in recent days, has pushed up fertilizer prices, as well as the cost of trucking food from farms to local markets and shipping it abroad. Then there is climate change. Harvests have been seriously disrupted by freak weather, including prolonged droughts in Australia and southern Africa, floods in west Africa, and this past winter's deep frost in China and record-breaking warmth in northern Europe. The push to produce biofuels as an alternative to hydrocarbons is further straining food supplies, especially in the U.S., where generous subsidies for ethanol have lured thousands of farmers away from growing crops for food. Not only those importing crude oil, but the oil producers, like Venezuela, Saudi Arabia and Russia, are also witnessing price pressures as their economies are flushed with money coming from crude oil sales. Recently, President Bush and Secretary of State Rice even went to the extent of blaming China and India's rising middle class (and their consumption) as the main reason behind the rising commodity prices.

Price pressures across the world are reaching levels that may soon threaten economic, political and social stability. Inflation rates have reached: Venezuela (22%), Vietnam (21%), Latvia (18%), Qatar (17%), Pakistan (17%), Egypt (16%) Bulgaria (15%), The Emirates (11%), Estonia (11%), Turkey (9.7%), Indonesia (9%) Saudi Arabia (9.6%), Argentina (8.9%), Romania (8.6%), China (8.5%), Philippines (8.3%), India (8.24%), Eurozone (3.6%), US (3.9%). Food prices have doubled in three years, according to the World Bank, sparking riots in Egypt and Haiti and in many African nations. Brazil, Vietnam, India and Egypt have all imposed food export restrictions which is only expected to aggravate problems further. Rising food prices threaten a surge in violent protests across the world, the Red Cross has warned.

Speaking of India, rising prices have brought a flurry of problems for the current UPA government. Prime Minister Manmohan Singh and Finance Minister Chidambram, who are credited with initiating the reforms that led to opening of economy, are under severe pressure emanating from price rise. Rising crude oil prices and depreciation of local currency (Rupee against Dollar) has finally forced the government to take bold step, the latest being the substantial hiking of fuel prices (Petrol, Diesel, LPG). Though the step is expected to check some of the losses of downstream oil companies (primarliy PSUs), experts are unanimous that the move will go a long way in pushing up the headline inflation numbers.

Soon after the hike was announced, Petroleum Secretary MS Srinivasan said the increase in fuel prices would raise inflation by 0.5 to 0.6 percentage points.

"Assuming the base inflation for the week ended June 7 to be around 7.8 per cent, we are looking at a WPI inflation number of 8.5-9 per cent over the next few weeks. Factoring in the probable revisions by around 40 basis points to the provisional inflation numbers, the actual inflation level is likely to be over 9.5 per cent," said Saugata Bhattacharya, vice-president (business and economic research), Axis Bank.

Crisil's Principal Economist Dharmakirti Joshi expects the WPI to go up by 51 basis points (bps)as a direct effect of the price hike. Lehman Brothers' India economist Sonal Verma also said that inflation rate could touch 9.5 per cent for the week ended June 7. "A lower base last year will further add to the inflation rate," she added.

Inflation rate stood at 4.28 per cent for the week ended June 9, 2007. Lehman Brothers has also revised its annual inflation estimate for 2008-09 to 8.5 percent from the earlier forecast of 8.2 percent. Rajeev Malik of JP Morgan Chase Bank (JPM) feels that the headline inflation is likely to go upto 9.5-10%.

RBI in an attempt to take control of the situation, has taken a very hawkish stance when it comes to policy interest rate. Trading in futures of some essential commodities has also been banned by the Finance Ministry, though the merit of such a move has been questioned.

No doubt due to raging inflation, Indian equity markets have lost favour with FIIs (commodities based economies like Russia and Brazil have emerged as hot destination). Brazil is up 9% and Russia is up 7% since early December, while India (Nifty/Sensex) is down 21% and China is down 31%. India imports 70% of total domestic crude oil consumption and hence higher crude oil prices coupled with a falling rupee/inflation has made the economy vulnerable. Corporate profits have come under pressure as input costs have risen. Higher inflation is also putting pressure on consumers’ disposable income and has thus brought down the consumption levels. IT companies, who were earlier sulking due to rupee appreciation (it affected their profitability), have been lately booking fresh losses on their hedged position in forex market due to sudden depreciation in rupee's value. However, analysts are still upbeat over the long term growth story of the Indian economy.

Thus, the key to rein in current level of international inflation lies in taming the crude oil prices. Increasingly, a consensus has been emerging the world over that the current bubble formation in commodities is a fallout of Ben Bernanke's aggreesive move of slashing interest rate to counter losses arising from subprime crisis. Histroy testifies to the fact that in recent times, a number of bubbles have formed due to the actions of central bankers. The most striking example is the housing bubble of US (which roughly began in 2001), that was a product of Alan Greenspan's move of keeping interest rate low in order to counter the recently busted IT bubble (1995-2001). The bubble was finally pricked in 2005-2006, and the sector, which then went into a slump, has yet to recover from it. Any type of economic bubble is difficult to identify except in hindsight, after the crash.

There are indications that we are soon going to see a coordinated intervention in the foreign exchange market by the leading central bankers of the world. Ben Bernanke has recently given indications that he is done slashing of interest rates and may now think of raising them. ECB's Trichet has already made his mind to go ahead with raising the interest rates. Already, China, India, Malaysia, Indonesia are following tight monetary policy since last few months. Above all, economies like India, Malaysia, Indonesia and Taiwan have gone ahead with reducing the government subsiddies on petroleum products and have raised the prices of fuel to check the artificial demand of crude oil. What effect all these steps will have on the international crude oil prices is something which will remain an enigma, at least for some time to come.