Another black swan?

The Dubai government's announcement that it would postpone debt repayments in its holding company sent markets roiling across the globe, triggering a sharp spike in the cost of insuring debt from a growing number of emerging and even non emerging markets including the likes of Brazil, Turkey, Hungary and Greece. The crisis, which began in the second half of 2007 with the collapse of the subprime mortgage market (as delinquencies soared), spread like wildfire into the highly leveraged banking sector, triggering a severe credit crunch which in turn prompted governments across the developed markets to instigate an unprecedented scale of intervention with an immediate aim of assuaging markets that were on the verge of complete collapse.

Until Dubai disclosed its problems, the general belief was that emerging markets had "emerged" out of the crisis relatively unscathed mainly, it was thought, as a result of the limited exposure they had to the subprime toxic waste. What pundits (once again) apparently failed to heed attention to were the implications of tighter credit standards to debt laden countries in the wake of the crisis. It basically meant that the "unscathed" emerging markets were having increasing difficulty in servicing the huge amount of sovereign debt that had been accumulated during the booming years preceding the crisis. It is difficult at this stage to asses exactly how serious the problem is, markets were certainly not expecting such a gloomy announcement from Dubai. If there is any certainty, however, it is that the crisis is still with us and probably for some time to come.

Paving the way for inflation?

It would seem a bit farfetched to expect a surge in inflation any time soon, especially given the dire economic conditions that continue to plague mainly the more developed countries. But then again it is when you least expect something to occur that it actually does materialize. Nothing could be truer in this regard than inflation expectations. The Federal Reserve or any central bank for that matter, has a dismal record when it comes to anticipating inflation. That is why most central banks actually shy away from overtly publishing their expectations.

A surge in inflation typically occurs when demand for goods and services outrun supply. Several indicators can provide a good idea of the risk of inflation in a given economy. One such example is the employment rate whereby the closer unemployment is to its "natural" rate, the greater is the probability that prices may surge (given that labor is the single most costly input in production). Another is capacity utilization which measures manufacturing ouput is to its full capacity. As with employment, the closer it is to its limit, the greater the risk of a surge in price. The problem with these measures are that they dont tell us much on their own (they need to be assessed in conjunction with other indicators) and also that they are not "forward" looking enough.

As for recent economic releases, one that drew my attention is business inventories with the latest figure signaling yet another drop, bringing stockpiles to their lowest levels since November 2005 (see chart). What this means is that if demand were to suddenly surge (unlikely if you ask me), U.S. businesses would be caught swimming naked and would have no other option than to jack up prices until enough capacity is restored to build inventory. It is indeed an inflation "red flag" but unfortunately doesnt tell us much in terms of probability of occurrence.