BIS warns of deflation

[zadok]

Global economy faces deep slowdown and deflation threat, BIS warns
By Edmund Conway, Economics Editor
Last Updated: 6:19am BST 30/06/2008

The central bankers' bank renews fear of second depression, writes Ambrose Evans-Pritchard

A year ago, the Bank for International Settlements startled the financial world by warning that we might soon face challenges last seen during the onset of the Great Depression. This has proved frighteningly accurate.

The venerable body, the ultimate bank of central bankers, said years of loose monetary policy had fuelled a dangerous credit bubble that would entail "much higher costs than is commonly supposed".

In a pointed attack on the US Federal Reserve, it said central banks would not find it easy to "clean up" once property bubbles have burst.

If only we had all listened to the BIS a long time ago. Ensconced in its Swiss lair, it has fired off anathemas for years, struggling to uphold orthodoxy against the follies of modern central banking.

Bill White, the departing chief economist, has now penned his swansong, the BIS's 78th Annual Report, released today. It is a disconcerting read for those who want to hope the global crisis is over.

"The current market turmoil is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point," it said. more...

[Slimprofits]

Re: BIS warns of deflation

78th annual report online

an excerpt from Part III - Emerging Market Economies:

Commodity prices have been on an upward trend since early this decade, showing particularly strong increases in the past two years. Rebounding from a temporary low in 2006, nominal US dollar oil prices rose 47% in 2007, and by early May 2008 had risen by a further 29%. Prices of food commodities, such as cereals and oilseeds (but also rice, which is not internationally traded in large volumes), have risen sharply since mid-2006. The performance of metal prices has been more mixed, but pronounced increases in copper and iron ore prices have also been observed (Graph III.5).

The extended upswing in the prices of some major commodities in the present decade reflects persistent demand growth that has not been fully accommodated by increases in supply. On the demand side, relatively easy global monetary conditions have supported robust global economic growth. This effect has been reinforced by the US dollar depreciation inrecent years, which has contributed to higher commodity prices measured in dollars.

According to a recent IMF estimate, a 1% depreciation in nominal effective terms leads to an oil price increase in US dollars of more than 1% after one year. Another important driver of the demand for commodities has been the very rapid industrialisation of countries outside the OECD area, notably China and, more recently, India. On the supply side, a number of constraints, including delays in the expansion of production capacity and higher production costs, have also played a role.

Some of these effects may be illustrated by developments in oil and food commodity markets. In the case of oil, global demand growth has averaged about 1.6% per year in this decade, but China’s demand has grown at an annual average rate of 6.7%. As a result, the share of China in global oil demand now exceeds that of Japan and Korea combined and is approaching that of OECD Pacific countries (Table III.2). The demand for oil in EMEs has been supported by government subsidies, which shield the population from higher prices and encourage the development of certain manufacturing sectors (eg automobiles). In a number of EMEs, including China, India, Indonesia and Malaysia, and in Latin America and the Middle East, governments still subsidise energy consumption at the retail level.

Even as demand has grown, supply constraints in some countries have boosted oil prices, despite increases in OPEC supply. According to current investment plans, Saudi Arabian production capacity is projected to increase from 10.5 million barrels per day (mb/d) in 2005 to 12.5 mb/d in 2009. By contrast, non-OPEC oil supply has been held back by the high costs of increasing capacity. For the four largest private sector oil companies outside OPEC, the cost of developing new oil reserves rose by between 45 and 70% over the period 2003–06. The costs of expanding production capacity for these oil companies are much higher than in Saudi Arabia or the United States. Overall spare capacity in the oil industry fell from around 5 mb/d in 2000 to a low of 1 mb/d in 2005, before recovering to 2.2 mb/d in 2007 Research indicates that low spare capacity contributes to higher oil prices. It limits the scope to increase production in order to offset rising demand pressures or disruptions to supply. It also means that larger oil stocks are required to smooth price fluctuations. However, global oil stocks have broadly remained stable since the early 1990s (Graph III.5, left-hand panel). The effects on prices have been exacerbated by geopolitical tensions and lower average oil inventories in some major oil-consuming countries.

In the case of food commodities, rapid GDP growth in EMEs in recent years has played a large role in boosting demand. This effect has been reinforced by structural changes, as rising per capita incomes, notably in China, have increased the demand for cereals, particularly for grain-fed livestock. According to Food and Agriculture Organization estimates, the consumption of cereals per person in developing countries rose by 20% between 1962 and 2003, while that of meat increased threefold. The demand effect on grain prices is amplified because, according to some estimates, two to five times more grain is required to produce the same amount of calories through livestock than through direct grain consumption. Around one third of global grain production was used to feed livestock in 2002. Government policies have also boosted demand for agricultural products. In particular, subsidies for biofuel production have increased the demand for maize and soybeans, which has in turn raised the prices of other food crops by diverting production away from them.

On the supply side, urbanisation has reduced the acreage devoted to farming in some EMEs. Higher oil and gas prices have also raised the cost of both fertiliser and transport. Government policies in advanced industrial economies, including restrictions on agricultural land use to support prices, continue to limit production responses to increased demand. Finally, lower stocks have added to price pressures (Graph III.5, centre panel). Supply constraints have been particularly apparent for wheat, which experienced poor growing conditions in 2006–07, although conditions have recently improved.

Are high commodity prices likely to persist? In the short run, slower growth in the United States will tend to reverse some of the recent spikes in commodity prices or at least dampen any further increases. However, commodity prices will be supported to the extent that the rapid growth in EMEs, and in particular China, can be sustained. The recent lowering of US interest rates also supports high commodity prices, and this effect will be reinforced if tight credit conditions in global markets eventually ease as expected. Over the medium term, some of the structural demand factors cited earlier, such as the continuing economic transformation of China and India, seem likely to persist. The above-mentioned supply factors and constraints (eg higher costs of agricultural and oil production) also appear likely to influence commodity price setting for some time to come.

[Guest]

Re: BIS warns of deflation

Commodity inflation is seen as a dampener of economic activity in OECD countries. As Andrew McKillop attempts to clarify to his readers, a robust commodities market shifts global flows of wealth to developing economies and actually has the counterintuitive effect of boosting global growth rates, as demographically these nations are a much larger share of global GDP. Hence the higher than average global growth rate we've witnessed in the past 7-8 years.

This has been discussed here at iTulip before, but the insight does not seem to stick, as the "unsustainable commodities boom built on US spenders" canard keeps making it's dreary rounds. Just when you thought it finally went away, it comes back again, like a nagging junior sibling to world growth. World growth is set to continue at above average trend, due precisely to that same commodities boom we consider the harbinger of "daflation" - it's the now thoroughly embedded macro trend for the next ten years or more.

Then when the final skeptics climb on board and concede that commodities booms foster higher global growth, the global hypergrowth phase will abate and break the back of the commodities boom. Meanwhile, at iTulip we'll keep reading the fearful prognostications the rest of this decade - expectations of a bubble burst in this sector lend an inevitable aura of "prudent realism", while in fact they have the effect of blinding one's observation of a large, secular, hypergrowth event.

Like the arrival of "moral justice" at long last however, at some point soon, the now weary proponents of a commodities collapse will have their (brief) day in the sun.