Surprise of the Year: Deflation Dissipation

(Stephen Poloz — Export Development Canada)

Each year, just before the holidays, we take a look back and recall the surprises that took place in the previous 12 months. 2007 was loaded with candidates.

Start with the world economy. We began the year with the world in decent shape, but concerned that the U.S. housing sector could surprise on the downside. Downside surprise indeed! Despite repeated reassurances from policymakers, the U.S. housing sector went into a meltdown and there is no evidence to suggest that it is over. The erosion of consumer confidence is affecting the rest of the economy, and economists are now open to the possibility of a U.S. recession.

As the year unfolded, many predicted that the rest of the world would decouple from the U.S. economy. Surprise again! The decline in the U.S. dollar over the year boosted U.S. exports and reduced U.S. imports, thereby directly spreading the U.S. slowdown to the rest of the world. Plus, the credit crunch that emerged in August – spawned by the U.S. housing meltdown, but surprising in its severity – immediately went international, and its effects are still growing today.

Slower economic growth generally leads to lower inflation. Besides, in recent years the world has been cushioned from inflation pressures by deflation in goods exported from China. Surprise again! Inflation is back on the policy radar screen. Oil is above $90 per barrel, wheat at $10 per bushel. The quality of some of China’s exports has come into question, leading many consumers to begin a switch to higher-priced alternatives. Plus, the growing awareness of global warming, supported by Al Gore’s receipt of the Nobel Peace Prize, will gradually embed environmental costs into consumer prices – thereby potentially creating a modest uptrend in global inflation.

It is tempting to blame political risk for high oil prices, which boosted the demand for bio-fuels, thereby pushing up food prices. Yet, factor in the surprising U.S. intelligence flip-flop Iran’s nuclear program, plus the apparent political shift in Venezuela, and the prices of commodities really do look surprisingly high. Although higher prices like these do not constitute inflation per se, consumers can’t tell the difference. Nor do they care whether the Canadian dollar shot above the U.S. dollar because of high commodity prices or pure speculation – the only unsurprising part of the dollar story was the brevity of its surge. In the end, it averaged about 93 cents in 2007.

And then, attentive readers will recall our surprise of the year in 2005 – the $39 DVD player – which then fell to $28 in 2006, prompting us to boldly forecast that DVD players could be free by Christmas 2009. Even this story, however, supports the deflation dissipation theme – a visit to our local rock-bottom retailer this Christmas found, surprisingly, the same $28 price point as last year.

The bottom line? These surprises underscore the massive contrasting tensions – between slowing economic growth and awakening inflation potential – being balanced by global financial markets today. 2007 was financially volatile, but don’t be surprised if 2008 is even more so.