ARE INFLATION & INTEREST RATE HIKES AROUND THE CORNER?

Roger Bootle, formerly, an eminent economist with HSBC, now a consultant on his own, had written a book 'Is inflation dead?'. He is speaking later this month with a new twist to the subject i.e. "Inflation reborn?". This would appear to indicate an inflection point in the economic cycles of the world;  caused principally by the happenings in the U.S. economy. It is true that if there is a sneeze there, the rest of the economic worlds catch a cold and the markets tend to get fits of pneumonia at times.

We have had some four years of benign inflation numbers and like all good things must come to an end, even inflation containment has its cost and price to pay. The politicians of the world, happily developed a healthy vested interest in keeping inflation low. The European Union (EU) had the convergence criteria; which kept its political masters in check, and therefore, there were very stringent targets in terms of budget deficit. In a sense, it is the U.S. that has been following a loose monetary policy of late; what with Bush's tax cuts, and a sudden disregard for the growing and gnawing budget deficit that have resulted in economic policies. More importantly, the defence expenditure and homeland security costs have now piled up, both overseas and within the country.

To an extent, recession, lack of job growth and the somewhat erratic consumer spending,  kept the perception of inflationary pressures somewhat muted. That again, is beginning to change, what with some good increase in job numbers in terms of non-farm payrolls.  Generally, the worker productivity in the U.S. has increased, while the U.S. Dollar has weakened to such a point, that the exports are now beginning to gallop, capacity increases and investments will begin to happen, and thereby, more jobs will be created. This will reach a crescendo, as further spending and largesse are promised to be doled out, by both candidates to their political constituencies.

The elections in India, Sri Lanka and in many parts of Europe will again loosen the reins on public expenditure. The EU is admitting, as members and associates, a whole new host of countries that are not used to the fiscal discipline that the core EU economies have been accustomed to. Therefore, if inflation does rear up and picks up momentum, then interest rate hikes cannot be far behind. Already, the U.K. economy is clipping along in a manner, warranting a further interest rate hike.

The Governor of the European Central Bank, Jean Claude Trichet is unable to deliver any interest rate cuts, and this is so ambivalent,  that the market is now resigned to not expecting anything in the EU world, which has by now, become a multi-track and a multi-polar maze.

The developing world or the emerging economies have had the benefit of low interest rates, thanks to the  low U.S. interest rates translating into lower debt service costs. But even there, the growth rate, whether it is in the Far Eastern countries, in India and China or in Latin America, have got to a point, where now, future interest rates will be the cause rather than the effect of some emerging inflationary tendencies in their countries. Some have very significant foreign debt service requirements and their bond markets are decidedly looking vulnerable.

The equity markets on the other hand, are still hurt by poor earnings announcements, having been thrashed down by a string of corporate scandals and technology downturn  in the past, as well as a whole plethora of ills that have plagued the secondary markets in most parts of the world. Except for those in the emerging economies, such as Pakistan, Thailand, India, Turkey and Russia, the stock markets in the major economies are struggling to come to terms with a lackadaisical performance.

In the circumstances, it is important to evaluate whether there will be sharp inflationary pressures. Many acknowledge that the next uptick in inflation and interest rate hikes, is more of an imminent reality and that interest rates have perhaps, bottomed out in most parts of the world. The evidence still suggests that any such increase in inflation and therefore, interest rates, would be modest. Suddenly in the U.S., possibly, Greenspan and his colleagues in the Federal Reserve, are marking time and will want to stay out of any action, and until after the U.S. Presidential elections; so that he is not accused of stymieing the incumbent's chances in any manner.

In other parts of the world, interest rates will move up, but none of this is likely to be dramatic and perhaps only 50 basis points, at best. The mature economies of the world are still coping with a poor economic turnaround. The stellar GDP and market performance of some of the emerging markets are mercifully predicated on some very strong economic fundamentals. Therefore, things should be alright and short of a disaster in those countries. In the case of a country like India or China, a physical or a financial meltdown, political instability, failure of monsoons or such critical factors could play havoc. All numbers from countries like China may well be suspect, because of the integrity and robustness of the statistical processes. All political systems have now got used to inflation being the principal disquieting  force.  Inflation is not likely to be stoked in a hurry by any populist slogans. So it might well be a case of then reshuffling the political cards and any spending priorities, with certain interested groups benefiting at the expense of the other. Nor is anyone currently seen as espousing socialist slogans or equitable distribution.

The only underprivileged are really the pensioners or those that are not organized enough to get their dues or increase in the share of the gains made, and these will be the ones most affected by inflation. But as long as there is a resolute action on that front, and the interest rates are kept somewhat low, with the introduction of safety-nets and support schemes, for those fixed income groups, such as pensioners, then, in a somewhat convoluted manner, a clumsy compromise might have been worked out by the political classes of the day. That itself is a cause for some left-handed cheer!

The author is General Manager of Emirates Bank.  However, the views expressed in this article are not necessarily shared by the Bank.

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