After raging across much of the world for the past year, inflation may be snuffing itself out. Economists say the US financial crisis and lower purchasing power are tipping the world into an economic downturn that is reducing overall demand for key commodities and depriving inflation of the oxygen it needs to keep driving prices higher.
Central bankers have been counting on just such an event so they can turn from fighting inflation to fighting the spreading economic slowdown. Inflationary pressures demanded that they tighten monetary policy by raising interest rates or imposing regulations to make funds harder to get; growing signs of slower inflation mean they can instead loosen monetary policy and cut interest rates to revive economic growth and stave off more job losses.
"Lower commodity prices should start to reduce headline inflation in most countries relatively quickly, particularly in emerging markets, where food and fuel make up a substantial portion of the consumer basket," said Lewis Alexander, an economist at Citigroup. "This combination should help to improve the trade-off that policymakers face between inflation and growth in most economies." Demonstrating the sometimes perverse logic that governs financial markets, stock markets have rallied on the growing perception that inflation will give way to a painful global slowdown.
After a rally on Friday on Wall Street that sent the Dow Jones Industrial Average up by more than 1.5 per cent, stocks across Asia rallied Monday, with Japan's Nikkei 225 Stock Average rising by almost two per cent and Hong Kong's Hang Seng index climbing by 3.5 per cent. After months of fears of stagflation, analysts said investors now appear eager to see the global economic glass as half full, even if it means bracing for a global economic downturn.
With skyrocketing prices for food sparking riots earlier this year from the Philippines to Egypt and Cameroon, news that food and energy prices are easing is undoubtedly good news. Commodity producers like the Gulf can cheer inflation's demise, too, analysts say: while prices are falling, they remain historically high. Unfortunately, the real picture behind inflation is much murkier. The problem is that inflation is moderating largely because of what economists refer to as "demand destruction". Falling house prices in the US and a growing unemployment rate have led to lower demand for gasoline, which is putting pressure on oil prices. Now many of the symptoms afflicting the US economy are showing up in other developed economies, including Britain, the European Union and Japan.
"People are looking at other side of the coin," said Mahmood al Aradi, head of financial markets at the National Bank of Abu Dhabi. "European economies are suddenly being affected and, if anything, are much weaker and, if anything, are going to go through more trouble than the US." And while economists agree that inflation is down, few agree whether it is well and truly out. Federal Reserve chairman Ben Bernanke thinks that lower oil prices and slower economic growth "should lead inflation to moderate this year and next". Some economists, however, believe that the Fed cut rates too aggressively and that inflation remains a threat. Others dispute whether inflation is likely to fall fast enough to give central banks room to be more accommodative.
Boris Cornede, an economist at the Organisation for Economic Co-operation and Development (OECD) in Paris, said Europe's slowdown was unlikely to cool inflation to within the target of two per cent set by the European Central Bank. "The question is, will it be enough to wind inflation back to within comfort level of monetary authorities," he said. "That cannot be taken as given." The latest figures from outside the US also offer a mixed bag. Inflation in Spain rose in July to 10.2 per cent, its highest in 23 years. But inflation in Singapore dropped to 6.5 per cent in July from 7.5 per cent in June.
Complicating the picture is that the shifting global economic outlook has sparked a rally by the US dollar. Economists caution that the dollar's rally is less a symptom of improving US prospects than the result of darkening skies over the economies that use the euro, the yen and the Australian dollar. But the dollar's rise is helping to reduce inflation, pushing commodity prices, most of which are priced in dollars, lower. That might help exports to the US by making them cheaper for Americans to buy. On the other hand, it could hurt exports from the US, which have provided a rare and important bright spot in an otherwise bleak US economic picture.
Demand for commodities remains strong in many emerging markets. In countries such as China, India and the UAE, prices are subsidised, which keeps costs for consumers artificially low. That helps keep demand higher than it might be if consumers had to pay market prices, boosting global consumption and supporting global prices. But faced with ballooning costs, many governments are starting to cut subsidies, raising prices locally. Those higher local prices may cut aggregate global demand, but push local prices higher. "This will lead to inflation being 'sticky'," said Hany Genena, a senior economist at Gulf Finance House Investment Bank in Manama.
The dollar's rally could also help ease the liquidity crunch in the US as investors move capital to America to profit from the dollar's recovery, but make it worse everywhere else. Sign are already emerging that the credit crunch is spreading with the slowdown to the UK and Europe. Credit is getting tighter in the Gulf as well. Regional banks and companies are having to compete for capital with international borrowers. And with the dollar recovering, investors who had parked money here betting that authorities would let Gulf currencies rise against the dollar have rapidly pulled their money back out, reducing the money supply.
That phenomenon alone is helping to curb inflation in the Gulf, analysts say. But for a variety of reasons, falling inflation abroad may not translate directly into lower inflation here in the Gulf. Property speculation remains the biggest inflationary force, and until new supplies come on to push down real estate prices that may not change. Moreover, lower prices for imported goods might not immediately be passed along to consumers - importers typically raise prices more quickly than they lower them again.
Much of the inflation in the Gulf, moreover, is a symptom of distribution bottlenecks. At Jebel Ali, for example, capacity constraints are keeping container vessels anchored offshore for up to four days before unloading, a situation that is exacerbating tight supplies for goods and equipment in the UAE's booming economy. Such constraints aside, analysts expect that falling global prices will eventually translate into lower inflation. "Inflation here will react to correcting commodity prices worldwide," said the National Bank of Abu Dhabi's Mr Aradi. "Inflation will be a lagging indicator to demand."
warnold@thenational.ae