Inflation rekindled in nonchalant markets

Central banks are pump-priming at the most aggressive pace in decades, governments are hiking sales taxes, food and energy costs are surging and yet investors seem strangely casual about inflation risks.

For sure, there's a powerful argument that recession has left too much spare capacity in the labour markets, housing, factories and office space of the big western economies to allow price bottlenecks to drive consumer price inflation higher.

But for all the debt-hobbled economic funk in parts of the United States, Europe and Japan, global growth at large is still well above trend rates in excess of 4 percent and global monetary policy is switched to ultra loose.

Many of the biggest developing economies, such as China, India, Russia, Brazil, Turkey and Indonesia, continue to grow briskly and inflation is running at a 5 to 10% clip.

"The pick-up in input prices has come through globally, not just in the emerging world. Higher inflation in the emerging world has implications for the developed world," Janet Henry, economist at HSBC, told reporters this week when flagging the biggest quarterly rise in the inflation component of HSBC's emerging markets index in more than two years.

In essence, aggregate global demand affects global prices regardless of slack in the west.

Energy prices are up almost 20% in the past three months. Sugar, corn, soybeans and coffee prices are up more than 20% over the same period, some up more than 50% through 2010. Add tax rises, like Britain's 2.5 percentage point increase in value-added taxes to 20% this month, and even more pressure builds.

Stripped to nought

You can strip all these "volatile" twists out of inflation but many people's real experience of prices does have an impact.

As many groups, not least wage bargainers and social groups defending the poor and old, grow weary of policymakers and wage setters ignoring such substantial rises in their cost of living, inflation expectations among the public at large are starting to gain some traction.

The University of Michigan's consumer survey on one-year US inflation expectations jumped back to 3.0% last month from 2.2% in September. The Bank of England's equivalent indicates one-year inflation expectations have jumped to 3.9% almost twice the bank's 2% target.

And yet financial markets in the United States and euro zone continue to price inflation-protected debt securities with implied inflation rates of less than 3% on a five-year horizon.

So does relaxed policy and relatively nonchalant market pricing mean everything's in hand? Well, there are a few worriers and not just commodity bulls and gold bugs.

Morgan Stanley's chief US economist Richard Berner and his team reckon US inflation is nearing an "inflection point" and will soon start to move higher from the current 1.1%.

"By midyear, we think investors' outlook for inflation will begin to change as the forces pushing inflation higher start to gain the upper hand," Berner told clients.

If so, are central banks such as the Federal Reserve and the Bank of England who are not only pinning interest rates close to zero but still actively printing money justified in remaining so comfortable with a big output gap?

Output gap errors

Well, this is where it gets trickier. One of the biggest academic criticisms of policymakers' failure to prevent rampant double-digit inflation in the 1970s was that they completely misjudged the extent of the economy's spare capacity, which is nigh on impossible to see in real time.

Berner at Morgan Stanley also adds the wrinkle that the direction in which the output gap is moving, and not just its overall level, may have major effects on inflation rates and expectations. This he calls the "speed effects."

In effect, it means a trough in operating rates or a peak in jobless rates has an impact not only on cyclically-sensitive global prices like energy and food but also in areas like rents, which are a major component of US consumer price indexes.

Although US vacancy rates remain high, they are falling fast and rents are up almost 5% in the year through November, according to data cited by Morgan Stanley.

All this may also imply that, faced with huge sovereign debts and variety of lingering financial stability problems, the world's central banks are prepared to become a little more "flexible" with inflation targets and goals.

In a paper on inflation targeting last month, Swedish Riksbank board member Lars Svensson highlighted among other things the extension of time horizons for reaching those targets from two to three years recently in Britain, Sweden and Norway.

Yet greater tolerance of higher inflation in the short run may still have a profound effect on markets and expectations. For investors, it may be wise to expect a bumpier ride from now.