News Update

Inflation to hit 6 per cent in 2009:

CIBC World Markets

Inflation in the U.S. will hit six per cent within the next six months forcing the Federal Reserve Board to raise interest rates by at least 200 basis points, forecasts a new CIBC World Markets report.

The report notes that the American economy has not seen an inflation rate this high since 1990 - and that only lasted four months. "You've got to go back to 1982, in the midst of the stagflation that followed the second OPEC oil shock, to see the last time American inflation was clocked at that kind of pace for any sustained period," says Jeff Rubin, chief economist at CIBC World Markets.

Mr. Rubin notes that soaring energy prices are once again driving inflation concerns but that high prices are emboldening the bargaining positions of many U.S. workers. "Soaring energy costs are rapidly turning global cost curves on their head. As shipping costs soar with triple digit oil prices, the once omnipotent threat of Chinese competition is growing fainter every day. And the same energy costs that now protect American workers with soaring freight costs are at the same time eating away at their pay checks at the gas pumps."

The result of these factors is the likely return of cost-of-living allowances (COLA) in North American wage negotiations, particularly in highly organized industries like steel, where soaring freight rates are the equivalent of double digit tariff protection. He notes that high energy prices give American manufacturing workers bargaining power that they have lacked for over a decade while at the same time encouraging them to ask for larger pay raises to keep pace with the soaring price of gasoline.

"Back in the 1980s, most collective bargaining agreements of the day had cost of living allowances built into the wage scale," says Mr. Rubin. "Those COLA clauses largely became self-fulfilling prophesies by ensuring that largely oil price driven inflation would become self-sustaining through a wage-price spiral."

With changing labour rates building in inflation clauses, Mr. Rubin expects that interest rates will also have to rise. The report notes that when inflation rates touched six per cent in 1990, the Federal Reserve funds rate was running around seven and a half per cent, over three times what it is At the same time, a 10-year Treasury Bond was yielding 8.5 per cent over double what it yields.

"We expect that the Federal Reserve Board will raise interest rates no less than 200 basis points by the end of next year," adds Mr. Rubin. "History says we will be very lucky if they don't have to do more." The report finds that despite the recent decrease in global oil prices, supply pressures will continue to drive crude costs up which will translate into higher consumer prices at the pump, at the grocery store and at the electricity meter.

Mr. Rubin notes that an exploding thirst for oil and waning production in the Middle East saw crude exports from the region drop by over 700,000 barrels a day in 2007. While producers in the region claim they will be able to boost exports, the bank's research points to a further decline in exports of one million barrels per day in the next four years.

"If world oil markets are to see new supply over the next four and a half years, it won't be coming from OPEC," says Mr. Rubin. "While exports fell in 2007, daily oil consumption in the Middle East itself climbed by some 300,000 barrels (per day). The increase matched the increase recorded by China, a country with quadruple its population."

The report notes that oil consumption has not only been driven by huge energy subsidies at the gas pumps that see motorists paying a tenth or so of the prevailing global rate but by a rapidly growing demand for electricity that is fuelled by "even more egregious subsidies for oil and gas-fired electricity". Subsidies across the region see power consumers paying anywhere from a half to just a 14th of what a typical North American household is charged.

Since the region has no coal or nuclear electricity plants, and has very limited hydro capacity, the region relies on plants fuelled by fossil fuels. With some of the world's fastest growing populations, electricity consumption in the region has increased by more than six per cent annually since 2002 and now consumes some 320,000 barrels of oil per day. With Saudi Arabia looking to triple its electricity capacity by 2020 and other jurisdictions like Dubai - which has the highest electricity demand growth in the region at 15 per cent annually - switching from scarce natural gas to oil, electricity consumption will continue to climb at two to three times the rate in the OECD.

A growing population and a growing economy have also intensified the region's need for fresh water - something in increasingly short supply. Natural water production in Saudi Arabia is already down 50 per cent from its mid-1990s peak. Current water use in the country is seven times the sustainable level with consumption levels in the United Arab Emirates and Kuwait running at 15 and 22 times the level of natural replacement.

This is driving an urgent need for more hugely energy-intensive desalinization plants. According to the World Bank, over the next 10 to 15 years, the Middle East will need an extra 50-60 billion cubic feet of water annually. Desalinating that immense volume could ultimately require one million barrels of oil per day or its energy equivalent in natural gas.

Mr. Rubin says that despite OPEC's recent claim that it has no responsibility for triple digit oil prices, his research found that the cartel's practice of highly subsidized oil consumption will continue to reduce exports from the region. That in turn will drive both oil prices and inflation higher.