A jump in import demand for construction materials threatens to rekindle inflationary pressures on global commodities, reversing the current downtrend that began last year. Heightened commodities prices will add to higher input costs for global manufacturers, whose margins are already under pressure from elevated wages. If manufacturers pass on these higher production costs, we could see an increase in goods price inflation. At a time when services inflation is proving stubborn, a resurgence in goods prices will negate the hard-fought gains in the nascent disinflation process. The third uncertainty is fresh shocks to food and energy prices. Lower global food and energy prices have largely facilitated the fall in global headline inflation so far. But the nascent disinflationary trend may be interrupted by a rise in food and energy prices. For instance, in January this year, firm food and energy prices elicited strongerthan-expected inflation outturns. Upside shocks to food and energy prices can emanate from a few sources. Unfavourable weather conditions could dampen agricultural yields. This happened in Asia in January. The fall in OPEC oil output remains a factor underpinning some firmness in oil and gasoline prices. An escalation in geopolitical tensions could contribute to bouts of volatility in commodity prices. So, what does all this mean for financial markets? Financial markets may take a while to adjust to this new regime of higher interest rates, and that adjustment may not be smooth. We witnessed last year how such a disorderly adjustment could unfold, when central banks raised interest rates at an unprecedented pace.
There was already some inflation in spring 2001 and a rapid slide in the exchange rate of the króna until the end of November 2001 caused inflation to increase substantially, from around 4% when inflation targeting was adopted to 9½% in the beginning of 2002. Inflation surged following heavy demand pressure in the economy which was driven by large-scale credit expansion and resulted in an enormous current account deficit, peaking in 2000 at 10% of GDP. For most of the period of overheating the Central Bank did not follow a direct inflation target and the backbone of monetary policy was a fixed exchange rate, with a fluctuation band, i.e. a soft exchange rate peg. Nonetheless, the Central Bank sought to counter inflationary pressures as soon as 1999 and began raising interest rates, which caused the króna to strengthen until spring 2000. Expectations changed then, partly under the impact of the wide current account deficit, and the currency inflow diminished. A downward exchange rate trend then began. The Bank raised its policy interest rate in phases until the end of 2000 when it reached 11.4%, where it remained until spring 2001 when a minor cut was made. The interest rate remained unchanged until late 2001 when the Bank felt it could discern clear signs that inflation was beginning to come down again. By then, the exchange rate of the króna had fallen by almost one-third from its highest point in spring 2000.