More rate hikes, but inflation could prove persistent

There has been no let-up recently in global monetary policy tightening.

India raised interest rates on Wednesday. South Africa raised rates yesterday. With industrial production in the euro area rising 0.9 percent in April, the ECB is likely to raise rates next month after noting in its latest monthly bulletin that "risks to price stability over the medium term have increased further".

The Federal Reserve could hike rates too, especially after yesterday's economic data. From Bloomberg:

Retail sales in the U.S. rose twice as much as forecast in May as Americans used their tax rebates to shop at electronics and department stores, and record gasoline prices swelled service-station receipts.

Purchases climbed 1 percent, the most since November, following a 0.4 percent gain the prior month that was previously reported as a drop, the Commerce Department said in Washington. Purchases excluding gasoline increased 0.8 percent last month.

But the US economy is far from out of the woods.

Initial claims for unemployment benefits rose to 384,000 last week from 359,000 the prior week, the Labor Department also reported today.

Still, the Federal Reserve has to watch out for inflation.

A separate report today showed that prices of goods imported to the U.S. rose 2.3 percent in May from the previous month, less than economists had forecast.

Disinflation from China is no longer helping out on this front. From AFP/CNA:

China's inflation rate was 7.7 percent in May, easing from April's 8.5 percent, the government said on Thursday, as analysts cautioned that some prices had been kept artificially in check.

Food prices have eased but, at the same time, price controls meant pent-up inflation had accumulated in the world's fastest-growing major economy, according to economists...

"We all know about fuel and electricity controls, but we hear reports of firms in the food and construction industries also being told not to raise prices," said [Standard Chartered economist Stephen] Green.

"There is a lot more bottled up inflation in this economy than meets the eye."

A surge in China's money supply in May certainly does not suggest that inflation is moderating, although FDI does appear to be slowing.

Morgan Stanley economists are not convinced that there will be all that much tightening to come though. From a recent commentary by Joachim Fels and Manoj Pradhan:

Central bankers around the world continue to worry about ‘stag’, but ‘flation’ has now become their main concern. This is the loud and clear message sent by monetary policy decisions and hawkish comments over the past week or so...

Our central bank watchers around the world remain less impressed by the hawkish rhetoric than the markets. The one notable exception is in the euro area, where Elga Bartsch now expects the ECB to follow up words with action in the form of a 25bp rate hike in July and another one later this year. Yet, in the US, the UK and Japan, our central scenario remains that policy rates will be left unchanged this year... Also, we don’t expect a tightening of monetary policy in Australia and Switzerland this year, even though the risks in these countries are probably skewed towards a rise. Norway and Sweden look likely to hike, but only once, and we maintain our call for 75bp of rate cuts in New Zealand.

They conclude that inflation is likely to prove persistent in the coming years.

We looked at what would happen to the real monetary policy rate between now and end-March 2009 if central banks would in fact raise rates as implied by the money markets right now and if inflation behaved as our country economists are forecasting. Initially, the real rate would fall further into negative territory as headline inflation rises sharply in the next few months, but thereafter the real rate increases due to easing headline inflation and the rate hikes that markets expect. However, by end-March 2009, the real policy rate would only go back to zero in this simulation. In other words, monetary policy would still be expansionary at that point, unless one believes that the neutral rate of interest is zero too (we don’t). We conclude that inflation is likely to be a persistent problem in the years to come. This is not to say that inflation won’t fall after this summer. However, we are likely to see higher average inflation rates and higher peaks and troughs in the next inflation cycle(s).