As economic growth weakens, look for inflation to moderate

Global inflation is rising. With economic growth, particularly in the United States, slowing, it looks like a case of stagflation -- weak economic growth combined with high inflation. However, this condition is unlikely to last.

In the US, the Labor Department reported last week that consumer prices rose 0.4 percent in January, the same rate of increase as in December. Food and energy were big contributors to the rise but even excluding these items, prices were up 0.3 percent compared to 0.2 percent in the previous month. Over 12 months, overall consumer prices were up 4.3 percent while prices excluding food and energy rose 2.5 percent.

As further evidence of the underlying inflationary trend, other measures of core inflation also showed acceleration last month. The 16-percent trimmed-mean consumer price index monitored by the Cleveland Federal Reserve rose 0.4 percent in January, higher than the 0.2-percent increase in the previous month, while its median consumer price index rose 0.3 percent, maintaining the pace of the previous four months.

	Aug	Sep	Oct	Nov	Dec	Jan
CPI	0.0	0.4	0.3	0.9	0.4	0.4
CPI less food & energy	0.2	0.2	0.2	0.2	0.2	0.3
16% trimmed-mean CPI	0.1	0.3	0.3	0.3	0.2	0.4
Median CPI	0.2	0.3	0.3	0.3	0.3	0.3

The 12-month rate of consumer price inflation now shows an accelerating trend according to all the four main measures monitored by the Cleveland Federal Reserve.

	Aug	Sep	Oct	Nov	Dec	Jan
CPI	2.0	2.8	3.5	4.3	4.1	4.3
CPI less food & energy	2.1	2.1	2.2	2.3	2.4	2.5
16% trimmed-mean CPI	2.4	2.5	2.7	2.8	2.8	3.0
Median CPI	2.9	3.0	3.0	3.1	3.1	3.2

Inflation is not just a US trend. It is very much a global one.

In Europe, reports last week showed the same trend. Producer prices in Germany rose at an annual rate of 3.3 percent, the highest in 13 months. Based on EU-harmonised standards, French consumer prices rose at an annual rate of 3.2 percent in January, up from 2.8 percent in December, while Italy's consumer prices rose at a 3.1 percent rate in January compared with 2.8 percent in December.

Even China, whose exports many believe helped keep inflation elsewhere down in the 1990s and early 2000s, is facing inflationary pressures of its own. Last week, it reported that consumer prices were up 7.1 percent in January from a year ago, the highest rate of inflation in 11 years.

So is inflation running out of control? Officials at the Federal Reserve do not think so, at least in the US.

According to the minutes of the Federal Open Market Committee meeting on 29-30 January released last week, Fed officials have been disappointed by the inflation readings of recent months. They have raised the projection for inflation in 2008 based on the personal consumption expenditures PCE price index to between 2.1-2.4 percent from the previous range of 1.8-2.1 percent. Projection for 2008 inflation in the price index excluding food and energy was also raised to 2.0-2.2 percent from 1.7-1.9 percent. The latter is essentially the same as the actual rate seen in the fourth quarter of 2007, indicating that Fed officials think that inflation at what it believes is the core level will remain stubborn through the year.

However, the minutes also show that Fed officials believed that slower economic growth anticipated for the first half of this year would produce enough slack in resource utilisation as to result in an easing of price pressures. The projection for economic growth was reduced to a range of 1.3-2.0 percent from a previous range of 1.8-2.5 percent.

Fed officials have publicly stated on various occasions that they do not expect a recession. An outright recession, though, is precisely what would make a significant dent on inflation. At least that has been the case in the past, as the accompanying chart shows.

The economic reports last week, however, have not clearly indicated that the economy is in recession or will be in one soon, although they do underline how weak it is. The Federal Reserve Bank of Philadelphia's index of manufacturing activity fell this month to -24 from -20.9 in January. The National Association of Home Builders/Wells Fargo housing market index edged up from 19 in January but to only 20 in February. Housing starts edged up in January too but building permits fell 3 percent.

Leading indicators are pointing in the same downward direction. The Conference Board's US leading index decreased 0.1 percent in January and has now fallen 2.0 percent over the last six months, with only two out of ten components having advanced over the period. The Economic Cycle Research Institute's weekly leading index fell to 132.3 in the week of 15 February from 133.1 in the prior week and its annualised growth rate deteriorated to -10.2 percent from -9.2 percent, reaching its lowest reading since the week of 26 October 2001.

So if weaker economic growth does create the slack in resource utilisation that the Federal Reserve envisages, there may indeed by hope for inflation in the US to moderate later in the year.

Europe's economy is projected to develop along similar lines. According to the European Commission's latest forecast of the economy released last week, growth is expected to slow to 2.0 percent this year in the European Union, 0.4 percentage point less than forecast in November. Inflation this year is expected to average 2.9 percent in the EU, half a percentage point more than the previous forecast. However, it is expected to recede to just above 2.5 percent by the end of the year.

So cyclical factors driving up inflation today are widely expected to diminish over the next year or so.

Beyond that, however, the aggressive interest rate cuts by the Federal Reserve over the past few months should eventually reflate the US economy. Unless the economy weakens more severely than most economists expect, inflation is likely to become a concern again for policy makers before too long.

In fact, at the last FOMC meeting, according to the minutes, Fed officials had noted that inflation expectations had risen in recent months and some officials suggested that once prospects for growth improves, a reversal of the recent monetary easing, possibly even a "rapid reversal", might be appropriate.

Inflation may not be as virulent as some think, but it is probably not going to be easily buried either.