Global Outlook – Inflation decoupling

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There has been a notable divergence in global inflation trends over the past year. Among the twenty large economies that we monitor, ten have seen an increase in consumer price inflation, while the other ten saw a decline.

Among the countries where inflation has moderated, the majority are in the Eurozone, where inflation was forced down by euro appreciation, weak domestic demand and relative cost adjustments (see chart 1).

The currency’s more recent reversal will put some upward pressure on inflation over the coming year, but declining commodity prices, a weak economy and futher relative price changes will work in the other direction.

If the ECB wants to lift inflation out of the danger zone, it will have to follow Japan’s lead sooner rather than later. India and Indonesia are the only large emerging economies where inflation has declined significantly over the period.

Unlike Europe though, weaker inflation is a positive development that will relieve pressure on their central banks and make it easier to push through needed reforms. The recent plunge in oil and agricultural commodity prices will lower inflation further in the coming months, as energy and food prices make up more than 50% of their price baskets.

The countries where headline inflation has increased since mid-2013 fall into two main camps. In the first camp are Brazil, Russia and Turkey. All are plagued by the structurally high inflation that results from poorly designed product and labour market regulations, entrenched high inflation expectations and central banks that have paid insufficient attention to their inflation targets.

Turkey will benefit from the recent falls in commodities, but it is a mixed blessing for Brazil and Russia. While they will likely enjoy some moderation in headline inflation, both are net exporters of commodities and the resultant deterioration in their terms of trade will weigh on their already very weak domestic economies.

Meanwhile, inflation is likely on a long upward trajectory in the US and Japan. In the US, domestic inflation pressures are gradually building as labour market slack continues to erode. In Japan, the jump in inflation has been triggered by the April sales tax hike and the Bank of Japan’s massive policy stimulus, which has led to a 28% depreciation of the exchange rate over the past two years and a tightening in the labour market.

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