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BY INVITATION
PAUL DONOVAN
All of a sudden, the world's central bankers are talking about inflation expectations. European Central Bank president Jean-Claude Trichet started the process by saying that he was "strongly determined" to anchor inflation expectations. US Federal Reserve chairman Ben Bernanke recently said that his central bank would "strongly resist" any erosion in price expectations. This led markets to contemplate the possibility of increasing interest rates.
So what are inflation expectations doing? In the OECD, companies' inflation expectations are stable. Companies do not believe that they can raise inflation in an environment of weakening growth, and reduced consumer credit.
For consumers in the OECD, there is a different story. Here price expectations have shot upwards. In the United States, consumers are expecting inflation to increase more than 7% year-on-year in the next 12 months. Inflation in America has not been more than 7% since 1982. Inflation expectations of European consumers are up significantly, at levels not seen since the introduction of the euro notes and coins.
So is there a problem? UBS research suggests that companies are generally good at predicting levels of core inflation. Corporate management is good at predicting future pricing power. Stable corporate price expectations suggest that central banks need not be concerned, and that inflation will be contained.
Consumers' price expectations, in contrast, are not very accurate. In fact, consumers are generally very bad at predicting inflation. Future expectations are strongly influenced by current perceptions. Current inflation perceptions, in turn, are influenced by the price of things bought on a daily basis - food, petrol, newspapers. While important items, these are only a part of the overall CPI basket, hence consumers' inaccuracy in predicting inflation. If consumers are bad at predicting inflation, and consumer expectations are the main area of increasing inflation expectations, why are central banks sounding worried?
The answer lies in what economists call "second-round effects". Consumers may not be accurate in their price expectations, but those expectations might influence the wage increases that they demand from their employers. Those wage increases in turn could influence broad price levels (labour costs are the most important part of inflation).
Central banks are looking for continued wage restraint in the face of higher food and energy prices. If there is no wage restraint then the risk is of a return to the 1970s - a wage price spiral. If there is wage restrain, then inflation is no threat. Indeed, if inflation expectations are not matched by wage growth, there is a risk that consumers will believe that their standard of living is being damaged. That causes consumer confidence to fall.
The cost of labour in the United States and in Europe does not suggest that wage restraint need be a problem. Inflation expectations for consumers are higher, but those consumers do not seem to be able to do much about it when it comes to wage demand. In the first quarter US unit labour costs at just 0.7% compared to the first quarter of 2007. In the euro area, negotiated wage settlements achieved a 0% increase year-on-year at the end of last year.
In Thailand, data on inflation expectations is hard to come by. However, the minimum wage deal earlier this year between employers, labour representatives and the government made it clear that inflation expectations have risen. Moreover, anecdotal evidence suggests that cost of living allowance increases are common in many private sector firms. And as the government allows further price increases for consumer goods on the basis of higher costs, it seems that "second-round effects" are coming to pass in Thailand.
UBS believes that inflation will remain controlled in the OECD economies, but that it is a bigger problem in emerging markets. For all the talk of concern about OECD inflation expectations and wages, there is no evidence that this is a problem yet. Raising interest rates in emerging markets seems a sensible strategy.
Paul Donovan is deputy head of global economics for UBS Investment Bank.
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