Stephen King: Why 2004 is unlikely to become another 1994

There?s no real evidence that the inflation geniehas been allowedout of the bottle

Earlier this year, it appeared that the West was about to embark on one of its periodic bouts of inflation. Commodity prices were rising swiftly. Oil prices were particularly strong. Activity was picking up. And, with interest rates very low and monetary policy very loose, a lot of commentators began to believe that central banks were "behind the curve". Our monetary masters had left interest rates too low for too long and were now paying the price: years of investment in anti-inflation credibility were in danger of being frittered away.

This view was so widely held that people began to talk about another 1994. That was when the Federal Reserve tightened monetary policy a lot more aggressively than markets had originally expected, leading to a collapse in global bond markets that, in turn, left many fixed income traders nursing their wounds.

Yet, so far, 2004 has not been a repeat of 1994. It's true, of course, that monetary policy has been tightened. It's also true that the Fed gave the impression earlier this year that it wanted interest rates to head back up to "neutrality". Beyond that, however, the differences are perhaps greater than the similarities. As soon as interest rates went up this year, the global economy appeared to slow down. Rather than collapsing, bond markets rallied. Perhaps most interestingly, the inflationary fears that formed earlier this year no longer appear to be justified.

The latest consumer price data in the US shows that inflationary pressures are fading fast. The headline inflation measure is still a little high - 2.7 per cent in the year to August - but that's primarily the result of higher energy prices. Even here, however, there has been a marked improvement. Two months earlier, the year-on-year rate peaked at 3.3 per cent, so the acceleration in headline inflation that seemed to be coming through earlier in 2004 is now a thing of the past.

One obvious way to show this change of direction comes from a quick look at the three-month change in US prices expressed at an annual rate. In the three months to May, this measure of headline inflation stood at 5.5 per cent, high enough to make any central banker feel a little uneasy. In the three months to August, however, the rate had dropped back to just 1.3 per cent.

If we take away the volatile food and energy components, so-called "core" inflation never picked up quite so much in the first place, with the annual rate peaking at 1.9 per cent in June before dropping back to 1.7 per cent in August. Using the three-month annualised change to get a better idea of recent trends, "core" inflation now stands at just 1.0 per cent, less than one-third of the 3.3 per cent rate recorded in the three months to May.

If this turndown in inflation is maintained, the Fed will find itself in a very odd position. At the end of its 4 May policy meeting, it stated that "the risks to the goal of price stability have moved into balance" - in other words, that a pickup in inflation to an unacceptably high rate was just as likely as a decline in inflation to an undesirably low rate. The markets - rightly - saw this statement as a signal that interest rates were about to rise.

This is a rather different message from the statement made at the end of last October. On that occasion, the Fed judged that, "on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future". In other words, it was worried about a possible descent into deflation, conjuring up all sorts of apocalyptic economic images.

I've used these two statements for a reason. In May, inflation was picking up rather rapidly and, had the acceleration been maintained, the Fed would have every reason to push up interest rates to significantly higher levels. But the rapid deceleration in inflation over the last three months takes the three-month annualised core inflation rate almost back down to the pace seen last October, when the Fed was much more concerned about deflation than inflation. Is this a case of going back to the future?

Why hasn't inflation taken off? Why is it that higher oil prices, for example, have not led to the wage-price spiral that markets feared? Based on the economic experience of the Sixties, Seventies and Eighties, we came to believe that cost shocks would typically feed through to price shocks. The "cost plus mark-up" model of inflation seemed to work reasonably well: control costs and inflation would look after itself.

Over the last 15 years, however, the evidence increasingly suggests the "cost plus mark-up" model no longer describes the world in a helpful way. These days, a cost shock - in the form of higher oil prices, for example - is less likely to lead to higher inflation and more likely to lead to adjustments, either to other costs or to the "mark-up"; in other words, profit margins. Inflation remains well behaved: instead, there is a redistribution of income. An oil price increase, for example, would lift incomes for oil producers but lower incomes for workers, through higher unemployment or lower wages, or companies, through lower profits.

The absence of a "wage-price spiral" in the light of a cost shock reflects at least two structural factors. Firstly, central banks now have a lot more anti-inflation credibility than before. Independent central banks armed with a price-stability mandate and distanced from the effects of the electoral cycle tend to be taken seriously by wage and price setters. Secondly, the globalisation of product, labour and capital markets has moved us increasingly towards a global "law of one price". Companies find it increasingly difficult to pass on cost increases through higher prices, so they try to offset cost increases in one area with cost reductions elsewhere (hence the increased move towards outsourcing and offshoring).

On top of all this, there are one or two post-bubble factors at work. Following the collapse in equity prices, the US economy was given a shot in the arm through a combination of aggressive tax cuts and rapid reductions in interest rates. These economic "plasters" are now washing off, perhaps exposing some of the underlying frailties of the recovery and, therefore, reducing pricing power. Meanwhile, although US companies appear to be cash-rich, having de-leveraged over the last three years, there is little evidence to date that they can think of anything much to do with this cash: having invested perhaps too much in the late 1990s, they are having difficulty coming up with any ideas that will deliver a suitable return.

Overall, then, the conditions for a sustained acceleration in inflation were never there in the first place. There's no doubt that the sudden rise in inflation that occurred earlier this year was unnerving but, so far, there's no real evidence that the inflation genie has been allowed out of the bottle.

If anything, the latest data has provided the Fed with a completely different set of problems: should they carry on raising interest rates on the back of a - possibly faltering - cyclical recovery in economic activity, or should they now return to their earlier structural concerns about deflation? They don't have to decide yet but, if the inflation numbers remain this low, it will increasingly look as though we never really left the structurally deflationary world that has dominated proceedings since the turn of the century.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com