The worldwide inflationary climate has been rather benign recently. Rising inflationary pressures in selected emerging markets, an increasing worry in 2010, have decreased. Deflation in Japan is decreasing, which is a welcome development. Headline inflation in the other major economies is hovering around comfortable levels as shown in the graph. Inflationary expectations have risen somewhat. A recent source of worry is the steady rise in the price of oil since December 2011 partly as a consequence of rising tensions between Iran and the West. A second source of worry is the ultra-loose monetary policy in the major developed markets, especially the recent LTRO operations by the European Central Bank. Both sources of worry will be discussed briefly in this note.
Oil price shock?
For several years the Iranian nuclear program has been a source of tension between Iran and the West. The departure of US troops out of Iraq opens a door of opportunity for a unilateral Israeli attack to Iranian nuclear facilities, as the Iraqi air space is no longer controlled by the US but only by rudimentary Iraqi forces. The shortest route to Iranian facilities is via Jordan and Iraqi airspace. Iranian nuclear progress has so far not resulted in an Iranian ‘bomb’. A strike would set back the Iranian program for at least a couple of years and - who knows- could possibly provoke a regime change in Iran itself. For historical reasons it is also unlikely that an Israeli prime minister just watches and stands by when a sworn enemy comes closer and closer obtaining a nuclear bomb. Of course, there are also a host of counterarguments. The operation is difficult and on the edge of Israel’s military capabilities. There is a significant risk that it will fail to attain its objectives which would amount to a tremendous loss of face and morale. After two disappointing campaigns in Afghanistan and Iraq the US is reluctant to engage into a third war. As the west won’t be prepared to send any ground troops, Iran cannot be kept from nuclear development forever. The setback of the program could turn out to be only a couple of years: is this really worth the effort? Apart from the United States, at least two other major powers i.e. China and Russia wouldn’t support a preventive strike (a superficial glance on the map shows the enormous strategic importance of Iran as key to central Asia). A strike could stiffen the current Iranian regime and be a rallying point for general resistance to Israel. Israel has moreover an estimated 200 operational nuclear warheads and a credible second strike capability (three modern subs). Iran is therefore easily deterred. All in all it is impossible to predict the likelihood of a unilateral Israeli strike against Iran. But it is important to realize that this is ultimately a decision of the Israeli government, which cannot be blocked by the United States.
After a strike Iran would probably retaliate. A possibility is that it would try to hinder oil transports to the west by closing the important Strait of Hormuz provoking naval intervention by the United States, increasing the chance on a regional war. Oil prices would temporarily sky rocket. The IMF warns of a price hike of 30%. As energy is for instance 8.6% of the US price index, headline inflation could be pushed up easily by several percentage points. This would most likely not lead to a change in the current ultra-loose monetary policy in developed markets. But as the consequence of an oil price shock would most likely be highly deflationary for the already weakened world economy, the rise in inflation would be temporary. It would hasten the rise of gas as the most important alternative source of energy. At this stage we doubt that an oil price shock would be a catalyst for a structural higher inflation rate in developed markets.
Emergency measures by the European Central Bank
Recently, the European Central Bank has stabilized the European debt crisis, by flooding the European banking system with liquidity, amounting to EUR 1 trillion (gross). The net effect is smaller, as part of the funding is used to refinance banks. Moreover, new capital requirements are pressing banks to shorten their balance sheets. The overall economic effect of the recent emergency measures by the European Central Bank is therefore hardly sufficient to prevent a credit crunch for the European economy. At best, it has stabilized the system. In our view, longer term inflationary risks have not risen. But the European debt crisis is far from over. In the end the European Central Bank has to bail out systemically important countries against all costs. A failure to act would lead to a break up and be highly deflationary. Additional bail-outs will certainly contribute to higher inflationary risks in the future, but for the dynamics it is important to keep in mind the famous ‘long and variable lags’ of Milton Friedman by which an ultra-loose monetary policy ultimately will result in higher inflation. As Europe currently is sliding towards a recession, it will be years before inflation will raise its ugly head significantly…It is not a short term issue.