The sharp rise in asset prices globally aided by abundant liquidity is a cause for concern
The Economic Survey released recently states: “The economy has undergone a transition—possibly structural and permanent—from high to low inflation in the last three years.” Inflation in India in the last four months has been hovering close to 2%, which is a historical low. To put it in perspective, average inflation in India for the last five years was close to 7%. Disinflation trend witnessed in the country is being mirrored globally, which brings us to the pertinent question whether we have reached a prolonged phase of low global inflation. If the current levels of low inflation are the new normal, then the policy makers need to take that into account.
A look at the global inflation trend shows that in the US and the EU, CPI inflation remains below 2% (their inflation target). In Japan, inflation is less than 1% and, in China, while the producer price inflation has been showing a rising trend (after being in the negative territory from 2012 to 2016), CPI inflation has remained in the range of 1-3% since 2012. Inflation in India has been falling below the central bank’s forecast. As per the Economic Survey, in the last 14 quarters, inflation has been overestimated by more than 100 basis points in six quarters. So has been the case for the US economy—core inflation (as measured by personal consumption expenditure, PCE) has been undershooting Fed’s forecast.
Global CPI started gradual downward movement from 2011 onwards. The fall in global commodity prices—including energy, industrial, metal, agri—was a big factor supporting low global inflation. Global crude oil prices fell to $40-60/bbl level in the last three years from $100/bbl levels seen in 2014. However, it is not just supply-side factors, core inflation globally has also been low. Core inflation is a measure of demand-side inflation, and is calculated after deducting components like energy and food, which are influenced more by supply-side factors. Core inflation of the OECD countries has remained below 2% since 2009. This is despite the fact that global growth has been improving and unemployment reducing in the last couple of years. In the US, the unemployment rate has fallen to 4% in 2017 from 10% in 2010, and in Germany the unemployment rate has fallen below 4% from 7% in 2010. According to the Phillips curve, lower unemployment should result in higher wages and higher prices. However, this phenomenon is not being seen in most countries. For instance, in the US, the wage price inflation has been hovering in the range of 2-3% since 2013.
To some extent, low core inflation globally could be a reflection of low demand and unutilised capacity. However, mechanisation, better technology and global trade also appear to have pushed down prices. According to an IMF study, the decline in inflation globally has been larger for manufactured/tradeable goods than those for services. Even in India, services inflation (driven by health, education, house rent, airfare) averaged 4.5% in FY17, falling below 4% in FY18. Since 2016, global commodity prices have started inching up, to some extent reducing deflationary pressure globally. However, global commodity prices are unlikely to shoot up to the previous commodity super cycle levels. China, the big guzzler of commodities—accounting for 40% of global aluminium consumption and 50% of coal consumption—has cooled down. In 2016, China recorded GDP growth of 6.7% as against growth of 12-14% recorded at the peak of commodity super cycle (2006-07). As far as crude oil is concerned, increase in price beyond a particular level will bring US shale producers back to the market. This would increase crude oil supply in the market and again pull down prices. The cooling down of Chinese economy and emergence of shale oil will ensure that commodity prices will not increase sharply on a sustained basis in the near future. This, in turn, could imply prolonged period of low global inflation.
Globally, central banks have been hesitant to hike interest rates, given the low level of inflation. This has resulted in interest rates in developed economies like the US, the EU and Japan remaining very low for the last 10 years. However, with economic growth improving, central banks run the risk of fuelling asset price bubble, if they continue with low interest rates. Stock markets globally are on a bullish run. MSCI global stock market index has risen by 12% and the MSCI emerging markets stock index has increased by 17% in the last one year. There is growing threat of housing bubble in countries like the US, Canada, Australia, China, and some parts of the EU. In the US, the Case-Shiller Housing price index has reached levels last seen during the 2006-07 housing bubble. In China, as per the latest data, new housing prices in 70 major cities have increased by 10% year-on-year—this is after the cooling down in housing prices seen in the last few months.
The sharp rise in asset prices globally aided by abundant liquidity is a cause for concern. The dilemma for central bankers is the low level of inflation. However, if the low global inflation is structural, then monetary policy authorities in economies like the US and the EU need to tighten monetary policy as economic growth improves. Otherwise, central banks run the risk of another global asset price bubble.