This is another way of looking at something I've mentioned before: the distinction between inflation in things a country produces, versus inflation in things a country consumes. Policy-makers now fear deflation But it's helpful if the price of something a country consumes, but doesn't produce (that is, it's imported), falls. This boosts real incomes (and so makes it easier to service debt). As Exhibit 5 shows, the US saw this 'good' deflation in 2009.

Conversely, it's unhelpful to see inflation in the things consumed but not produced. That reduces real incomes, and increases real debt burdens. That, at the margin, is the sort of inflation commodity importers now face. Simply put, 'importing' inflation does not reduce the debt-deflation tail risk.

So here's the point: the EM-driven rise in commodity prices will likely lead to weaker terms of trade for many developed economies (Australia and Canada the clear exceptions). Moreover, currency weakness can worsen the terms of trade.
(This is because developed world export prices tend to be 'stickier', while commodity prices, set globally, quickly reflect currency adjustments.) While this effect may be relatively minor for the big developed economies, it's another headwind
in a tepid base case.

Finally, commodity prices will remain solid in a world with at-trend growth (which is our macro team's base case). It would be best for the strong EM countries to respond by letting their currencies appreciate, muting the inflation pressure, but maintaining solid growth. Yesterday's Chinese rate increase points to a less investor-friendly response: domestic tightening, while keeping its currency low.

Eoin Treacy's view Industrial metals and energy prices have been overshadowed by the explosive action in soft commodities following a dismal summer for crops globally. However, with food prices looking set to rise further, industrial metals trending steadily highs, cotton close to historic highs, lumber advancing and oil holding in the region of the upper side of a yearlong range one can't but help to think about the inflationary pressures this is fostering.

A number of countries outside the G4 have already begun to normalise interest rates and China joined the group this week. While some Asian and Latin American currencies have become somewhat overbought versus the Dollar in the short-term, the medium-term prospects for additional strength remains positive for the simple reason that the respective economies are growing faster than the G4 and trade between such markets is increasing at a prodigious pace.

Through its dominance of global manufacturing China has contributed to a lower the cost of production across a range of consumer goods and by extension has exported disinflation over the last decade. However, margins, particularly in low end manufacturing, are now razor thin. Wage pressures are increasing to such an extent that factories are beginning to move inland in search of cheaper workers. (This article from Bloomberg carries more on the subject) They are also beginning to move to other jurisdictions which perhaps offer low cost labour but not the same economy of scale. The medium-term implication is that the cost of manufacturing is unlikely to decrease further.

When we combine the impact of higher raw material prices, a bottom in the cost of production for manufactured goods, Chinese wage inflation and similar trends in a number of Asia's population centres, then it is not much of leap to conclude that stagflation is a reasonable scenario for at least some of the G4 over the coming years.