Global inflation could derail Fed’s plan to bring rates back to normal

When the Cold War ended, the U.S. economy, along with those of many other countries, became more open. The share of exports and imports in the gross domestic product — a proxy for economic openness — indicated an acceleration in openness in the early 2000s. Around the same time, inflation rates around the world converged.
ENTER CHINA
China’s economic evolution in recent decades is relevant both to increasing globalization and its impact on inflation around the world. The divergence in Chinese inflation from that of the rest of the world in the mid-1990s reflected the Chinese economy’s opening up after the Cold War, as well as the local imbalance between pent-up demand and available goods, especially food items. During the 1997 Asian crisis, the shock to aggregate demand dropped inflation to the other extreme. Since the crisis, however, China has seen explosive economic growth driven by exports and infrastructure investments.
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As of 2010, China’s share of world commodity consumption stood at 53% for cement, 48% for iron ore, 39% for copper and 48% for coal, according to the World Bank. At that time, China’s GDP growth peaked at 12% and by 2013 official statistics were showing GDP at a still strong 8%. China underwent a political change of guard in 2012 and began the transition to a less investment-driven and more consumer-led economy. The Thomson Reuters/Jefferies CRB Index, a broad commodity index, peaked at 350 in 2012. One year later, commodity prices fell by 14%. This was the first leg of the global disinflation cycle, which has been largely a story of demand rebalancing.
DISINFLATION, OVERVALUATION
In line with the process of demand rebalancing, home prices in China have come under pressure recently and its stock market continues to look overvalued. The rebalancing in China has been an important factor in unleashing the global disinflation cycle that we believe we are currently living through. As the degree of the stock market’s overvaluation indicates, however, China still has a long way to go.
China’s economy has at least begun to stabilize as a new stimulus scheme, designed to replace trillions in questionable municipal bank loans with government-backed bonds, presumably could free up the balance sheets of local banks and encourage more lending. The program is off to a slow start because banks are reluctant to take down the bonds, but China’s economic indicators have at least remained near the trough, rather than continuing to decline.
A DEFLATIONARY TREND IN CHINA
If China’s stock market crashes further, however, the blow to households is likely to be severe enough to stop the improvement in its tracks. If so, inflation would decline, not just in China, but around the world.
Add to the list of worries the foreign exchange transmission mechanism. It has been in China’s interest recently to hold the yuan steady to support aggregate demand and get better recognition of its currency in international circles. However, the Chinese yuan represents 21% of the trade-weighted dollar. The euro is the second biggest weight at 16%. Weak economic growth and divergent monetary policy in other countries may feed into upward pressures on the U.S. dollar, according to the Federal Reserve.
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Meanwhile, the deflation story is becoming more entrenched in Asia ex-Japan in spite of the stabilization of inflation in the U.S. and Europe. Thailand’s consumer price index deflation experience is now increasingly widespread throughout the region.
THE STRONG DOLLAR
The strong dollar has been a common topic among investors recently and is equally relevant to the inflation outlook. By historical standards, however, we do not view the dollar as being overvalued. Looking at previous cycles, the dollar has tended to move in five-year intervals between bull, bear, and sideways trading patterns. Prior bullish trends have extended 47% on average and lasted about five years. In 2014, the dollar moved above 80 on the U.S. trade-weighted index (the high end of the range that has prevailed since the global financial crisis) and is currently 13% higher, according to the Federal Reserve.
MORE ROOM TO RUN
The first leg up in the dollar rally is still in the process of filtering through to core inflation, and as the historical record indicates, there could be further gains ahead. However, unprecedented monetary policy around the globe could affect historical cycles in unexpected ways.
Considering the global linkages in the assessment of inflation is important for all market participants. On one hand, given the background presented here (and the China story in particular), it is questionable whether the Fed will be confident that inflation will move back to its 2% objective. The path to interest-rate normalization could be slower than expected. On the other hand, for investors involved in markets that are fully valued by historical standards, the trajectory of inflation will impact performance.
Ion Dan is vice president, senior structured products analyst and trader at Delaware Investments.