Everything You Ever Wanted To Know About The World's Battle With Inflation But Were Afraid To Ask

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It is the du jour worry in the back of the minds of every investor and regular person on the street. But do people actually know what it means or how it works?

Prices are rising, that’s a fact. The U.S. Consumer Price Index and the CPI of any countries around the world indicate that prices are increasing on a variety of goods.

But that’s not necessarily a bad thing. Price increases suggest growth. And right now, the U.S. economy is growing, as are economies like China, India, and Germany. But that’s only one of the reasons prices are increasing across the U.S. and the world.

Another reason is the weather. The weather has slammed the global economy, reduced crop output, and increased prices for food around the world. All at a time where supplies were already low, and demand was rebounding.

But there’s another lingering concern; that all of the money the Federal Reserve and other central banks have added to the international finance system to combat the economic downturn is now moving from bank balance sheets to the market.

That stimulus is fueling the economic growth that driving the global recovery. It has been particularly effective in Asia, where now policy markers are pulling back those measures as inflation rises.

Where do we stand in the current conflict with inflation? And how did we get here in the first place?

The rebound in Asia was driven by aggressive fiscal and monetary policy

Asia's biggest economies, all concerned about the extent of the international downturn, put in place stimulus packages in 2009 and 2010 to pull their economies from the brink. This stimulus was both fiscal and monetary in nature, meaning it included the easing of interest rates and spending on infrastructure projects.

China's program included extensive loans, which eventually increased the country's loan to GDP ratio to 117.4% in 2009. China's fiscal program was worth $586 billion.

Source: Morgan Stanley, Wikipedia

The stimulus injection in Asia turned around the region's economies way faster than expected

What happened is, while Asia had been busy stimulating domestic demand through loans and other stimulus, the west turned it around too, with the U.S. and Europe both engaging in massive stimulus programs.

This coordinated world stimulus made the recession rebound take just as much time as those from the two previous Asian downturns, while it was much deeper.

That means the turnaround was way bigger, and inflation rose with it.

Source: Morgan Stanley

The inflation rebound hit the entire region, with China and India feeling it the most

But putting this in perspective: This spike is now weakening, and recent inflation, at its peak, is only back to 2008 levels.

This is not just an Asian phenomenon: Inflation is rising in Latin America too

In fact, it's pretty much up in every emerging market

One of the items impacted by price increases is food

You can see the rebound in food price inflation occurred just as Asia's economies turned around. That suggests the price spike was associated with the return of rampant Asian growth, as well as a push through impact of regional monetary stimulus.

The price spikes are a lot like those in 2008, but as of yet are not as high.

Source: Citi

Beyond the rebound in demand, Asia has been hit by the effects of the weather event La Nina

This reduces the supply side of the food equation. So while the region is rebounding, more people are employed, and spending is up, the supply of food is down.

Citi say that even before the weather effects were in place, there was a low supply of food stocks in Asia.

Source: Citi

Food prices have a large impact on headline inflation because they're weighted heavily in indices.

In some countries, the weight is as high as 50%. Notably, in China, the weight is over 30%. And while in India, food makes up a smaller portion of the country's CPI basket, it's also at record highs.

Energy prices, fuelled by the global rebound, are also contributing to the spike in food prices

The increase in energy prices is adding to the increase in food prices, through and rise in the cost of transporting goods. But the rise is oil prices is also increasing demand for biofuels, made from soya and corn.

Demand for oil has rebounded with the global recovery.

But it's important to note: WTI crude prices are actually down 40% from 2008.

Source: Citi

But how does the Asian inflation story get passed on to the U.S.?

The rising costs in China will eventually be passed on to U.S. consumers. As wages and commodity prices increase the cost of producing goods in China, so to will they increase the costs U.S. consumers pay when they shop.

Source: Societe Generale

But the recovery in the U.S. is also a chief cause for the rise in inflation

Inflation expectations in the United States have increased as the recovery has taken hold. That's only natural: the economy does better, people expect prices to rise.

Source: Societe Generale

But there's reason to believe this inflation spike will soon be tamed

The emerging world is in line for a significant round of monetary tightening. China, India, and Brazil have already started. Latin America is expected to tighten big this year. It's only Russia that is not.

Tightening outlook for the rest of 2011, according to Citi:

  • Brazil will raise rates by 1.5%
  • China will raise rates by 0.75%
  • India will raise rates by 0.5%

Source: Citi

Simultaneously, the weather is getting better

Farmers are going to plant more as result of this past year's high prices. And weather should, theoretically, improve over the course of 2011, and the La Nina effect dims.

Source: Citi

Now, if you're still bullish on inflation, here's where to look.

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