But how do we get there? The inflation merry-go-round provides the answer (see The Global Monetary Analyst: The Inflation Merry-Go-Round, January 26, 2011): i) super-expansionary monetary policy in the major developed economies is imported by emerging economies' central banks through (US dollar) soft and hard pegs; ii) having gained a toehold in EM, inflation is re-exported into developed economies through more expensive goods exports; and iii) ‘rationally inactive' central banks in developed economies accommodate this imported inflation, ultimately risking a domestic inflation take-off. ‘Rational inaction' on behalf of DM central banks encapsulates the notion that they will not respond to incipient inflationary pressures for reasons that are, individually, sound: financial stability considerations; reduced visibility over the medium-term outlook; and asymmetric preferences over inflation versus deflation risks (see The Global Monetary Analyst: Better the Devil You Know, August 18, 2010).
In short, our call rests on two elements: loose global monetary conditions and accommodation of imported inflationary pressures by DM central banks. (In fact, the oil price is part of this mix, as loose global monetary conditions increase both the demand and reduce the supply of oil: on the demand side, they increase energy-intensive growth in EM; on the supply side, rock-bottom real interest rates discourage oil production, as investing the proceeds from oil extraction only yields a low real return.) It is the combination of those factors that will, ultimately, result in higher inflation, in our view. In this sense, with the global economy at the second stage of the global inflation loop described above, we are now seeing the thin end of the inflation wedge.
Pushback. Why, we are asked, would the inflation-merry-go-round generate inflation this time round? After all, many EM currencies were pegged to the dollar back then too, and EM inflation rates were higher than in DM.
1. The unfolding US recession and ultimately the deep slump caused by the financial crisis are certain to have kept accumulating price pressures in check.
2. With DM monetary policy much looser now than before the crisis, the de facto monetary policy stance in EM is also much looser, relative to the performance of these economies - courtesy of the two-track nature of the recovery.
3. More importantly, if we are right about ‘rational inaction', the response of DM central banks to imported inflation pressures will be accommodative - certainly more so than before. This will generate a tug of war between inflation expectations - already awakened by QE - and the disinflationary effects of the existing amount of slack in the economy. The latter, however, may be less than meets the eye since the crisis is likely to have destroyed a lot of potential. In addition, slack is certainly narrowing, and the change as well as the level of slack affects inflation.
How to break out of the loop. Preventing the global inflation loop from spiralling upwards requires a circuit breaker. This would mean normalisation of global monetary conditions through either hikes in DM or EM regaining some of their monetary independence through allowing substantial currency appreciation against the dollar. (Note that the latter would mean a one-off increase in DM inflation; the loop, however, would be broken.) Neither of these seems on the cards. On our forecasts, the Fed (and the ECB) won't tighten until 1Q12. And EM currency appreciation sufficient to choke off the global inflation loop seems difficult - many EM economies will want to wean themselves off their export-led development strategy only gradually.
Are global monetary conditions becoming a prisoner's dilemma? We are therefore concerned that global monetary conditions might end up becoming a hostage to a prisoner's dilemma-style game between DM and EM policymakers. In a prisoner's dilemma (PD) game, two parties acting in isolation in the pursuit of their own self-interest will achieve an outcome that is undesirable for both. In this case, neither side chooses to tighten. That means tightening is delayed, and the inflation genie will be out of the bottle.
Solution: coordinate. If global monetary conditions indeed end up being the outcome of a PD game, improving on the likely outcome - i.e., avoiding inflation - will require coordination of the parties involved. That is, the solution is a concerted tightening of monetary conditions, with DM normalising rates (somewhat) and EM economies loosening their pegs vis-à-vis the dollar. This, in our view, would not only be desirable but also feasible. DM central banks have, in the past, cut rates in a coordinated fashion during the crisis. It is the fact that the global monetary game is repeated (indeed infinitely so) that gives scope for coordination. Coordination could happen under IMF leadership, and use the G20 as forum. Signs of coordination may also help contain inflation expectations globally and restrain commodity price rises. In addition, coordination in tightening should lower FX volatility for a while.
But we wouldn't count on coordination. Coordination would not be our central case. Instead, we think countries are more likely to normalise monetary conditions independently, which will probably mean too late from a global perspective - with the concomitant upside risks to the global inflation outlook.
Conclusion. The global economy is now at stage 2 of the global inflation loop. While it is probably too early to act to tighten global monetary conditions, the time to worry about the exit and begin coordinating is now.
Monetary policy too accommodative: We have long argued that the policy rate in Israel has been too low, a view that is also officially shared by the BoI, as well. The BoI has been in the process of normalizing rates for some time; however, taking various factors into account, such as credit growth, housing price hikes, real wage growth, overall momentum of growth in the economy and deteriorating inflation expectations, we believe that the prevailing negative real interest rates are not fully commensurate with the inflation goals. In our view, the policy rate that stands at 2.25% would need to rise faster to address these issues and especially to minimize the risk of expectations deviating significantly from the official inflation target range.
Starting with January inflation figure, the upper end of the target is likely to be breached: Based on our projections of inflation in the coming months but especially starting with January data, we expect the headline inflation to exceed the 3% upper border of the target range. This will partially be on the back of base effects but also rising commodity prices, lower support from the currency appreciation (as the BoI managed to slowdown the appreciation tendency) and continuing accommodative monetary policy stance. We expect headline inflation to remain outside the 1-3% range for most of 2011. We are revising our year-end forecast to 2.9%Y from 2.6%Y with an average rate of 3.3%. We are also raising our 2012 year-end forecast by 0.3pp to 2.8%Y, but in case the BoI acts faster to contain inflation, the risks to our forecast might tilt to the downside.
Real wages are rising and no evidence of a deceleration in house prices: One of the arguments during the recession in 2009 and the recovery during 2010 was that real wages posed no threat to inflation dynamics and that the purchasing power of individuals was not strong enough to lead to domestic demand pressures. Another argument was the presence of a sizeable output gap. Based on the real wage data at hand, we can clearly see that the situation has improved for households and perhaps not so much for inflation prospects. The fast growth rate of 2010, which we expect to have reached 4%Y, and the ongoing momentum that is likely to help post 3.8%Y in 2011 should see the output gap narrowing if not closing during the year.
In addition, and perhaps most importantly, there has been no sign of deceleration in house prices. At around 17%Y growth in 2010, house prices continued to pose a significant threat to achieving price stability. While the primary reason behind the problem is related to the supply-side constraints, the accommodative monetary policy does not help either.
Inflation expectations deteriorated and remain at the borderline: According to BoI data, 12-month forward-looking inflation expectations went up to 3% (if not slightly more in recent months) according to both market forecasters and the rate derived from debt instruments. With both the BoI and Governor Stanley Fischer's strong credibility in the eyes of market participants, we believe that any policy action would be rewarded.
Raising our policy rate tightening forecast and changing our rate profile: On the back of our inflation forecast revision and taking into account the likely adverse impact of higher concurrent inflation on expectations, we believe that the BoI will likely address the issue by hiking rates faster and more than our previous expectations. We now expect another 25bp hike to take place in February, followed by a 50bp hike in 2Q11 and a 25bp hike each in 3Q11 and 4Q11. Hence, we see the policy rate at 3.50% at end-2011. We are penciling in another 100bp hike in 2012, mostly a reflection of the general tightening expected by the US Fed and the ECB.
Non-policy actions on FX to make tightening decisions easier: In recent weeks, the BoI, along with the Ministry of Finance, has taken various non-policy measures to stem the appreciation of the shekel. These include the reporting requirement imposed on banks to declare non-resident investors' transactions in the FX market, a 10% reserve requirement on FX swaps, and the draft decision to remove the tax exemption on gains over short-term shekel instruments.
In our view, these actions could represent a new approach to prevent shekel appreciation and lower reliance on FX interventions while accelerating the normalization of rates. However, almost all macro fundamentals point to a stronger shekel and this is likely to materialize at one point. Currency appreciation therefore constitutes the biggest risk to our rate forecasts.
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