Sunday, June 18, 2006
Is Britain importing inflation from China?
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Last weekend I was playing badminton in the garden, after a fashion, using rackets and shuttlecock that were so cheap they were free. The garden games set, which included a frisbee and ball, was a gift from one of our well-known retailers - OK it was Marks & Spencer - for spending a relatively modest amount on their delicatessen range. The set was, of course, made in China.

china.jpg

We have grown accustomed to cheap imports from China. They have been responsible for the fact that, for many goods, the experience over many years has been one of falling prices. One of my favourite statistics has been that the average price of goods in the shops is no higher now than in 1997. In fact the news is better than that, goods prices are, on average, more than 10% lower than they were, thanks to the China effect.

Without it, keeping inflation down in recent years would have been much harder. It would have required significantly higher interest rates and meant much slower economic growth. China has played a big part in Britain’s successful run of non-inflationary growth.

Is this now coming to an end? That was the spectre raised by Mervyn King in his important speech last week. Warning of turbulent times ahead, the Bank of England governor said the following about China.

“Even in China, with its growing manufacturing base and large pool of labour, some indicators are showing upward pressures on export prices,” he said. “And in turn that is raising our import prices, over and above the increases resulting from higher energy prices.”

If that is true it has momentous implications, not just for inflation and interest rates in Britain, but also more widely. If even China with its huge labour cost advantages can’t keep export prices down, the world could be on the cusp of a big inflation. As for China itself, perhaps its competitive advantage will begin to diminish rather faster than experts thought, raising doubts abouts its long-term ability to conquer the world.

Two things are clearly happening at the moment. One is that Britain’s import prices are rising, and were up by 5.9% in the February-April period compared with a year earlier. A lot of that is due to oil but, even stripping out oil and so-called erratics, the rise was 3.2%.

It is also clear that there is upward pressure on wages in the big Chinese cities, notably Shanghai and Beijing. Inflation has been low in China but is creeping back up.

So was it right for the governor to put two and two together and conclude that rising Chinese costs are pushing up UK import prices? Hesitant as I am to challenge somebody as meticulous as he is, I am not convinced.

China’s export prices, according to data from CEIC, an emerging market database firm, are not rising. The unit value of Chinese exports in April was 4% lower than a year earlier.

Britain, unfortunately, does not have separate data for import prices from China. America, however, does. Its latest figures, published a few days ago, showed that import prices from China last month were 1.3% lower than a year earlier. Given the dollar has been weak, it seems unlikely exports from China to America have been falling in price, while those to Britain have been rising.

There’s one small caveat. The clumsy handling of the “bra wars” clothing quotas by Peter Mandelson, the EU trade commissioner, may have had the temporary effect of pushing clothing prices higher. Fundamentally, though, the benign China effect on prices will continue for a long time yet. The more production that is shifted from higher-cost locations to the People’s Republic the longer this effect will persist.

The monetary policy committee (MPC) in its May inflation report, had it right when it said: “Low-cost imports from China and other industrialising nations should exert continued downward pressure on import price inflation over the next three years.”

King’s concerns over import prices do, however, raise an interesting question. The Bank is powerless to affect what happens to inflation elsewhere in the world, or to stop global energy prices from rising. Should it, instead of targeting a measure of inflation that is heavily influenced by import prices, the consumer prices index (CPI), instead focus on a measure of domestic inflation?

This is the proposition examined by Simon Wren—Lewis, along with colleagues Tatiana Kirsanova and Campbell Leith, in an article, ‘Should Central Banks Target Consumer Prices or the Exchange Rate?,’ to be published in the Economic Journal this week. The exchange rate is relevant because, along with the China effect, the strength of sterling over the past 10 years has helped significantly in keeping inflation low.

The authors argue that a switch in the target to output price inflation - the rate at which UK firms are increasing their prices - would be justified on two grounds. One is that the CPI target may be inherently unstable because of feedback effects from interest rate changes to inflation via the exchange rate. The other is that the “welfare” costs of controlling inflation are borne by producers, not consumers, so a target focusing on them would be better.

The economists reject an explicit exchange rate target but say the Bank should also take into account in its decisions sterling’s overvaluation - the difference between its actual and “fair” or fundamental value.

I don’t think the MPC is about to change the way it targets inflation (or, rather, be ordered to do so by the Treasury), but this is food for thought As we approach the 10th anniversary of Bank independence, which has gone extraordinarily well, some questions are being asked. Has this period been very good for consumers but at the expense of the production side of the economy, which has borne the brunt of the squeeze on inflation and had to live with a high pound?

As it happens, all inflation measures are pointing the same way at the moment. CPI inflation rose from 2% to 2.2% last month, retail price inflation increased from 2.6% to 3% and “core” output price inflation went up from 2.2% to 2.4%.
That doesn’t mean base rates are about to rise, particularly with wages growth still weak. It probably does mean the next move will be up.

PS It’s been lonely, and I’ve had to endure a certain amount of ridicule, but I now have a friend. Lord Browne, the BP chief executive, told the German magazine Der Spiegel last week that in the medium-term oil prices will drop to $40 a barrel, and could fall further, to between $25 and $30. It has long been my view that when the current spike in oil prices subsided, prices would drop to $40.

Many people, it should be said, disagree with the proposition that prices will ever fall. They see rampant demand continuing from China and India and little prospect of additional supply. Both points were tackled by Browne, and by BP’s Statistical Review of World Energy 2006, also published last week.

Browne said the industry was still finding oil - he cited the discoveries in the Caspian Sea, Russia and Africa - and getting better at extracting it. On the demand side Peter Davies, BP’s chief economist, pointed to figures showing energy demand fell 0.1% in America last year, the first time since 1985 the US has combined higher than normal economic growth with falling energy consumption.

Oil demand rose 1m barrels a day in 2005, down from a 2.8m daily increase in 2004. Consumption growth slowed in China and elsewhere. “Market adjustments are beginning and will continue,” said Davies.“There has been a price effect already with coal and gas prices falling and oil consumption growth slowing sharply and inventories rising.”

Nobody expects $40 a barrel oil next week - Browne was careful to warn that high prices could persist for some time yet. They might go higher before going lower. But the fundamentals do not justify prices at current levels. Commodities have wobbled - gold is down by a fifth, silver by a third - and oil will wobble its way down too.

From The Sunday Times, June 18 2006

Comments

Great article as always. Interested by the fact about prices having fallen 10% since 1997. What is this a measure of? And if it is true, what has the 2%+ CPI of recent years been caused by? It is a great statistic, but one I think that is hard to take too much from. So many of the goods in shops (thinking TVs, computers etc) are of such different quality to 1997, that any price comparison is irrelevant.

Posted by: Simon Woolfson at June 19, 2006 08:02 AM

The figure I quoted was for the retail sales deflator - the price of goods in the shops. It shows the extent to which retail sales volume has risen faster than value over the past few years. So why have we still had inflation? In terms of the CPI, energy, alcohol and, most importantly, services, have given us inflation, not to mention the wide range of "administered" prices - effectively controlled by government.

You're right about changing specifications but the statisticians try to adjust for that. A standard TV in the CPI or RPI is every different now from what it would have been in 1997. That should mean double gains for the consumers - lower prices and quality improvements.

Posted by: David Smith at June 19, 2006 08:55 AM

An interesting article, David.

I'm intrigued by the idea of switching to target domestic inflation, as I think that the MPC will be feeling increasingly uneasy about its current (already revised) target.

In the end though I suspect that the effect may be the same. Just as my grandfather used to say "you don't fatten pigs by weighing them - even when you use metric!", I think that the government may fall foul of feedback effects from rising costs at the factory gate and perceptions of inflation when the vast majority of our consumer goods are imported.

According to the article and interestingly while the CBI says there's mounting inflation at the factory gate, it says an interest rate rise is not necessary - almost certainly because it is worried about the resulting effect on spending.

Putting aside the credibility problems associated with large disparities between actual and government-reported inflation, todays published report from the BofE on inflation expectations (covered by TimesOnline) shows a decline in "median expectations of inflation" from 2.7% to 2.5%, which perhaps points to their possible getout card. An official denial of rising inflation wouldn't be popular but might solve some problems in the short term.

After all, when your pigs aren't getting fatter, and switching from imperial to metric makes no difference, why not start arguing the merits of leaner pigs?

Posted by: Terry at June 19, 2006 08:52 PM

"Browne, the BP chief executive, told the German magazine Der Spiegel last week that in the medium-term oil prices will drop to $40 a barrel"

Oh no he didn't. What he actually said was :

http://service.spiegel.de/cache/international/spiegel/0,1518,421709,00.html

SPIEGEL: In other words, it's possible that prices could drop to below $40 a barrel again?

Browne: By all means. We can hardly expect prices to drop significantly in the short term, but it's quite likely that prices will average about $40 in the medium term.

That's not the same as 'will drop back to $40'. Plus

a) that is presumably including a fair bit of the economic cycle - including recession? You need a pretty juicy recession to reduce global oil demand, the early 90's barely managed it (-12kbpd in 1991, -155kbpd in 1993 compared to world consumption then of around 67000kbpd) you need something more like the early 80's to get a significant reduction. Demand effects become a lot more important in a world which doesn't have a Texas Railroad Comission or OPEC sitting on lots of spare capacity to increase supply.

http://www.bp.com/liveassets/bp_internet/globalbp/globalbp_uk_english/publications/energy_reviews_2006/STAGING/local_assets/downloads/spreadsheets/statistical_review_full_report_workbook_2006.xls#'Oil Consumption – barrels'!A1

b) The majors have traditionally been mean on their price forecasts, BP more than most. One reason for that is that it's very much in their interest to make noises of 'although we're currently selling the stuff for $70 of real cash, this is just a short-term blip and we're not very profitable really so there's no need to impose any nasty windfall taxes thanks very much Gordon'.

It's mebbe more interesting to look at the forecasts BP are really using for grown-up purposes, rather than a throwaway line in Der Spiegel. That lies in the fact that the UK oil SORP allows oil companies to assess their reserves based on whatever oil price they are using for long-term planning purposes. In 2003 BP were using $16 oil :
http://www.bp.com/genericarticle.do?categoryId=2012968&contentId=2019010

In 2004 it was $20 :
http://www.bp.com/liveassets/bp_internet/globalbp/STAGING/global_assets/downloads/B/bp_strategy_and_fourth_quarter_2004_transcript_byron_grote.pdf

And just 20 months after that $16 forecast they were using $25 for 2005 :
http://www.bp.com/liveassets/bp_internet/globalbp/STAGING/global_assets/downloads/B/bp_fourth_quarter_and_full_year_2005_results_presentation_supplementary_info.pdf

What are they using this year?

The SORP planning number is obviously a 'worst case', ultra-conservative view, which is why it's substantially less than Browne's "It might get down to $40 at some point in the cycle". But given that BP's previous 'long-term' forecasts given to the authorities were so useless that they had to be adjusted by over 50% in just two years - why should we take any notice of any of Browne's forecasts? I'd suggest that the futures strip is a better guide to the oil price than the misquoted words of one of the most 'optimistic' of the vested interests who has a terrible record of price forecasts.

Still, I look forward to your headline of "BP increase their official oil price forecast 56% in two years" :-))

Posted by: Hal at June 20, 2006 09:11 AM

Sounds like somebody has a vested interest in a high oil price. You left off the rest of the Browne quote: "In the very long term, $25 to $30 is even a possibility." I think I and others pretty accurately reflected what he said. Whether or not it happens is, of course, a matter of debate. My argument has always been that there is a significant overshoot in the rise from $20 to $70 a barrel, as in previous oil price spikes. I don't think we need a global recession to produce a levelling of in demand, just a return to more normal world economic growth. The current "purple patch" for the world economy, with growth of around 5% for three years in the row, is the strongest for more than 30 years and won't be sustained.

Posted by: David Smith at June 20, 2006 09:37 AM

Sounds like somebody has a vested interest in a high oil price.

Less of a vested interest than Browne fighting off windfall taxes....

I know it's awkward over the anonymity of the Net, but for the record I'm just a private investor who bought (figuratively and literally) the oil story back in 2000 and have followed it more closely than most people since then. I don't play the commodities markets directly, I just buy equities - and I look for companies that make sense in the low $40's. I'm quite happy with the idea of oil prices falling back from current levels over the next few years, although I don't see prices below $50 Brent in the absence of a major recession. And in that respect I'm joined by the likes of the President and Secretary-General of OPEC :

http://quote.bloomberg.com/apps/news?pid=10000006&sid=aPszx6m1wFU8

The average price of OPEC oil is likely to remain between $45 and $55 a barrel, al-Sabah said.

That ``price seems to have been helping to keep the market well supplied and at the same time not hurting the world economy,'' said OPEC's acting secretary-general, Adnan Shihab- Eldin.

They're referring to the OPEC blend, which being heavier and more sulphurous than the Brent/WTI that is normally quoted for 'the price of oil' typically trades at a $4-6 discount to those blends, so al-Sabah is looking at $50-60 Brent/WTI. I'd suggest that the President of OPEC is in a much better position to forecast the price of oil than Browne. ;-/ That kind of number seems quite popular in OPEC - for instance the UAE Energy Minister has also mentioned that level (http://archive.gulfnews.com/articles/05/11/30/10001342.html)

The reference to what level hurts the world economy is interesting - for instance the airline association IATA's economic outlook (http://www.iata.org/whatwedo/economics/index.htm) suggests that their members will lose $3bn this year at $66 Brent, but are forecasting $3.3bn net profit next year at $60 Brent. That corresponds to a ROCE of only 2% or so, which is clearly unsustainable, but I'd guess that the airlines could cover their cost of capital at $50-55 Brent? I don't follow airlines closely as they make such lousy investments, but there may be an interesting article for you there, as they're a major industry that's highly dependent on the oil price and their capex spending is very visible in Boeing/Airbus' order stats. How is that capex responding to high oil prices?

I think I and others pretty accurately reflected what he said.

Time was when 'pretty accurate' wasn't good enough for the Times.... :-)) It's an important distinction in my eyes, 'will go to $40' makes me think of a probability distribution where $30-35 is the 'most likely' price, '$40 is quite likely' makes me think that $45 is most probable.

I don't think we need a global recession to produce a levelling of in demand, just a return to more normal world economic growth.

Why do you 'think' that? That's certainly not the implication of the BP demand figures I linked to, you need an early 90's event just to dent demand growth. I imagine you have easy access to the relevant GDP figures to regress oil consumption versus GDP growth, might be interesting to see what the data says. I'd guess you'd see two relationships, with industrialised countries being able to manage 1-2% growth without increasing oil consumption (although their total energy demand may well go up, by using natural gas etc), whereas industrialising nations are far more dependent on oil for growth. One reason for this is that the industrialised nations import more energy in the form of products such as aluminium ingots, and oil in the form of air-freighted strawberries etc, which don't show up in their oil consumption figures as the consumption has been off-shored. I sometimes wonder whether BRIC will see such dramatic reduction in the reported energy intensity of GDP growth, as all the 'stuff' used by the OECD has to be made somewhere, with the associated oil consumption - and we're running out of places to offshore that consumption to.

The South Korea data in the BP spreadsheet is probably a good one to chart, as they became an industrialised nation in the course of that time series.

I agree with you that the US demand data (and the truck miles figures) is significant, although I'd suggest that last year was hardly a 'normal' year for the US energy complex from which you can extrapolate too much. In particular, the Katrina disruption meant that not only did you get short-term substitution from oil to gas, but the refinery outages meant that the US outsourced even more primary oil consumption than usual, flattering the 'oil demand'/GDP ratio.

Certainly their own government regards it as a blip : http://www.eia.doe.gov/oiaf/ieo/index.html - although reflecting what I said above, most demand growth with be outside the OECD, they forecast 18.3 million bpd demand growth between 2003 and 2015.

Interesting times - but I'm not selling my oil stocks just yet :-)

Posted by: Hal at June 20, 2006 07:51 PM

I hold no brief for Lord Browne but that seems a bit unfair and, as I say, his comments were accurately reflected - I'll leave off the "pretty" if that makes you happy. The problem is, if you look at it that way, everybody has a vested interest, and certainly OPEC does, as do the investment banks and hedge funds which have bought heavily into oil and commodities. Privately, OPEC members are operating on the basis of "when not if" oil prices fall. As I say, it is not going to happen overnight.

In terms of global growth and oil demand, this year and last world growth is running at 5%. continuing the best sequence for more than 30 years. This produced a 1.3% rise in oil demand last year, and an expected 1.5% (IEA) rise this year. As tighter monetary policy slows world growth, say to 3.5%, oil demand is likely to flatten or fall.

Posted by: David Smith at June 21, 2006 10:13 AM

I've found your two big articles on oil this year, I read most of your stuff in dead-tree form but had missed those two. Since talk is cheap, I take it you're shorting the heck out of 2008/9 Brent futures? You'll make a fortune if your analysis is correct.

OPEC does, as do the investment banks and hedge funds which have bought heavily into oil and commodities. Privately, OPEC members are operating on the basis of "when not if" oil prices fall.

I'm sure that they like me will happily give you $10-15 fall - it's just the sub-$40 that I have a problem with. The difference is that OPEC are in a position to affect prices in a way that I and Browne cannot. Or rather - OPEC can raise prices by reducing quotas, but they can no longer reduce prices by upping production. Which is the big difference between now and 1986. Even a drop in demand of 1Mbpd would have no effect on prices if OPEC chose to match that with a production cut - there was talk of such a cut in Q2 this year, but the traditionally weak quarter of the year saw higher than expected demand.

growth is running at 5%. continuing the best sequence for more than 30 years. This produced a 1.3% rise in oil demand last year,

Why cherry-pick one year's figures, when there's a much more robust set of data out there? Especially since 2005 was so weird - aside from the destruction of so much refining capacity in the world's biggest consumer (leading to considerable short-term substitution), you had frustrated demand in China as the refiners refused to sell at government-controlled prices (although obviously those low prices artifically increase demand, it seems to have been a net negative last year) and a couple of other exceptionals. Furthermore, the previous two years make tough comparatives, with GDP growth up 2.8% and 4.1% (worldbank.org) yet oil consumption up 3.6% and 4.3% (p9 of http://omrpublic.iea.org/currentissues/sup.pdf) on the back of eg a lot of diesel generator use in China as a short-term response to the black outs.

Obviously economic growth intersects with increasing oil prices, in 2005 average Brent was up 42% on the year before - but in 2004 it was up 33%, and in 2003 up 15%, which are hardly trivial (numbers all from BP result statements). And as I've already mentioned, there are several examples of industries such as airlines continuing to adapt, grow demand and make acceptable profits even at $55 Brent. Yes that represents a $10 fall from where we are now - but I'd suggest that sub-$40 Brent would trigger significant demand growth.

But even if demand grows at an unprecedented 0% for the next 5 years, and even without any supply disruptions from terrorists/strikes - I think we've got enough problems on the supply side. I can see pre-disruption supply growing at 1%/year, but it'll struggle to reach 2%/year IMO even at $50 Brent. And there's plenty of risk that the figure will be lower, given the lack of information about production and depletion rates in OPEC, and the extent to which OPEC are unsustainably 'thrashing' their fields at present. However, it will be difficult to build up that 5-6Mbpd 'cushion' of spare capacity that we've traditionally had, and as a result I reckon that the markets will maintain at least $10 of risk premium in the price, to reflect that risk of disruption.

But assuming zero disruptions, it comes down to figuring out what oil price will give you demand growth of say 1.5%/year. Of course, we will see disruptions, so the equation becomes one of the price that gives you 1.4%, or 0.9% growth or whatever. You say Brent below $40 will do that, I say it will be $50-55. I guess we just have to invest our cash appropriately and let the market decide who's correct.

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