2008 Budgets just became more difficult to finalise

Economic growth, Oil markets

Central bankers are like generals. They seem to prefer fighting their last war, rather than preparing for the next one. How else to explain their continued reluctance to recognise that higher food and energy prices are here to stay? As a result, interest rates now need to rise more than expected. Pity those who have to forecast demand levels for 2008 BudgetsPrices are rising all over the world. Brent oil prices have just hit new all-time highs in nominal terms, and Goldman Sachs are today forecasting that Brent will reach new highs in real (eg inflation adjusted terms) within the next few months. I wouldn’t argue with this possibility (see the ‘What price oil‘? posting from 5 July).

Equally food prices are on the upward path. They have pushed China’s inflation rate to 3.4%, with many local economists expecting it to rise to 4%-5% soon, according to a report in yesterday’s Financial Times. Whilst last week the Chairman of Nestle, Peter Brabeck, suggested food was set for a period of ‘significant and long-lasting inflation’.

Yet until very recently, most central banks, including the US Federal Reserve, steadfastly resisted any suggestion that they should be concerned by oil and food price inflation. Even last week, Chairman Bernanke argued that ‘if inflation expectations are well anchored, changes in energy and food prices should have relatively little influence on core inflation’.

Their stress on ‘core inflation’ dates back to the 1990’s, when commodity prices were on a steadily declining path, with occasional upward blips due to weather or other short-lived factors. As a result, central bankers stripped these elements out of their inflation assessment, on the basis that changes in food and energy prices introduced unnecessary volatility.

But this approach is out of date. By fighting the last war, central banks have kept borrowing rates at attractive levels for much longer than warranted by global economic conditions. If they don’t move quickly to catch up, then I fear that we could easily see 5% plus inflation rates next year.

This creates a major problem for the chemical industry as it prepares its budgets for the 2008-10 period:

• If central banks become serious about reducing inflation back to target 2% levels, then interest rates will have to rise by more than generally expected. Otherwise demand for food and oil will continue to rise, and to push up prices.
• But any move to increase borrowing costs will make life harder for consumers, particularly in the heavily-indebted Anglo-Saxon economies. This could cause today’s difficulties in the US sub-prime mortgage market to spread more widely.

These two scenarios could have widely different implications for demand over the 2008-10 period. Reconciling them into a formal budget will not be an easy process

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