World inflation scare nearing critical juncture

Reuters - Like the timing of most investment decisions, the moment to stop betting on higher world inflation may well be when everyone else starts worrying about it.

For sure, mass expectations of higher inflation have proven to be a self-fulfilling prophecy in the past via aggressive wage bargaining and firms’ greater confidence in their pricing power.

But timely and pre-emptive interest rate rises by the world’s major central banks too have proven to be powerful in containing those expectations.

So gauging that balance of risks right now has rarely been more critical to money managers. Are monetary policymakers prepared to tolerate a period of higher inflation to insure the nascent economic recovery? Or are they emboldened sufficiently by accelerating world growth to fire shots across the bow?

SIX MONTHS SINCE JACKSON HOLE

After six months in which some major central banks were still actively fostering higher inflation via near-zero interest rates and money printing, there seems to be a change of tack.

Financial markets at least are starting to bet again on monetary tightening this year in the major economies.

The European Central Bank last month deliberately raised the red flag about inflation risks and, for all the angst about euro sovereign debt markets, interest rate futures are now penciling in a quarter-point ECB rate rise by September.

The Bank of England -- meeting on Thursday and facing the highest inflation rate among major developed economies of near 4 percent -- is under even greater pressure to act. Markets are now betting on a UK rate rise as soon as May.

With inflation at just over 1 percent, the U.S. Federal Reserve is expected to lag. But even there, futures have shifted to price a move as soon as December.

The People’s Bank of China -- monetary guardian of the world’s biggest emerging power -- is already moving to push up official interest rates gradually to rein in inflation that is expected at more than five percent for January. It hiked again by another quarter point to 6.06 percent on Tuesday.

So if futures markets are correct and major central banks are preparing to mobilise against rekindled inflation, asset managers may be tempted to rethink the big asset price moves of the past six months -- all of which have had a growth and inflation hue.

Taking Fed chairman Ben Bernanke’s effective pre-announcement of the second round of quantitative easing -- dubbed QE2 -- at the Fed’s Jackson Hole symposium on Aug. 27 as a rallying point, it is curious to see what has moved since.

As you might expect, commodities and energy have taken the bulk of the inflation rush -- copper has returned a whopping 35 percent since then, oil some 16 percent and the broad CRB commodities index is up 26 percent.

Equities, fairly intuitively, also caught the reflation slipstream. MSCI’s world index has returned almost 20 percent.

Low-yielding fixed income is clearly the loser in an inflation scare, with benchmark U.S. and German bonds losing 6 and 7 percent respectively.

What is more surprising is how developed equity markets, where the U.S. Nasdaq index returned almost 30 percent over the past six months, have outperformed emerging markets. But, once again, watching the inflation cycle might be the best way to explain that -- catching the markets where prices were troughing in favour of those where they may be cresting.

The conundrum now is whether sabre-rattling from the central banks may warrant a reversal of all those relative assets moves. The hawks are certainly making noises again.

“The distinct improvement in the economic outlook since the (QE2) program was initiated suggests taking that re-evaluation quite seriously,” Richmond Fed’s Jeffrey Lacker said on Tuesday.

This is where it becomes a game of chicken. Can central banks avoid turning words to action if inflation subsides of its own accord? Would that negate a need to rebalance portfolios?

Food and energy prices, exaggerated in part by series of natural disasters and severe winter weather, have been largely responsible for driving up inflation rates for six months.

Even though there is some concern that these typically volatile prices have risen for longer than many had forecast, hopes remain that annual headline inflation will top out around mid-year, flattered by comparison with last year’s price surges.

What is more, five-year inflation expectations embedded in index-linked government debt prices continue to show a relatively relaxed inflation horizon close to 2 percent in both the United States and euro zone. The UK is an outlier at well in excess of 3 percent.

And on a global level forecasters remain relatively relaxed.

Barclays, for example, expects global inflation to peak at 3.1 percent in the second quarter of 2011 even though it sees world growth persisting at a 4.5 percent rate through year-end.

It reckons emerging market inflation has already peaked.

The key is whether central banks have the nerve to match the market’s current assumption of their response.

Morgan Stanley, for one, thinks central bank “reaction functions” have changed due to concerns about financial stability and uncertainty about the underlying economy.

“We think, in the short term, that central banks’ strategy will be one of rational inaction.”