What is basically going on at the moment?

The Western world continues to recover from the financial crisis. Continued productivity gains mean that unemployment remains high and corporate profits are rising. China continues to grow thanks to its credit-and-investment boom and artificially weak currency. Quantitative easing in the US is driving a boom in financial assets, which is having a positive (and reflexive) effect on the real economy. A continuing banking crisis in the Eurozone is undermining weaker sovereign bond markets there but is not having wider effects. Commodity prices are continuing to rise owing to strong global growth, and certain agricultural commodities are rising strongly on account of poor weather conditions last year.

What could disrupt this happy picture?

At the moment, the favourite market bogeyman is inflation. But where is this inflation? As I pointed out last week, it is only in certain commodity markets. It does not yet appear to pose an upward threat to developed world CPI’s.

A more subtle argument can be made based on the situation in China. Chinese food inflation, the result of the weather, global food prices and decades of underinvestment in domestic agriculture, is beginning to feed into wages, as evidenced by recent minimum-wage rises. This, it is argued, will mean higher Chinese export prices.

However, this is just a story — it is not something that is actually happening. The chart below shows US import prices from China. Prices are rising, and certainly China is no longer the deflationary force that it was before 2007; but import price inflation is far from dangerously high.

If we add the second-biggest source of imports after China, the European Union, we can see that inflationary pressures from that bloc seem to be abating. And import price inflation from the EU was considerably higher last year than inflation from China is now. Why is China a special threat?
Indeed, if the US is importing inflation from any country, it is from its third-biggest source of imports, Canada, which I now add to the chart. This is likely due to the high energy component of Canadian exports.
So Chinese import inflation looks muted compared to import inflation from the US’s two other main trading partners, and CPI inflation has remained low despite import inflation from the other partners having recently been markedly higher than import price inflation from China is at present. Could the latter become much more of a threat? Of course it could — China is, after all, having a big credit boom. But all sorts of things could happen. At present, the market is jumping at shadows. 

I do not disagree that there is a danger that China could begin to export inflation, especially as I do not expect the authorities there to tighten monetary policy aggressively. Yet Chinese import prices to the US have been rising on-and-off on a month-on-month basis for a while now, as the following chart shows.
Further, import price inflation from other trading partners has already been high and appears now to be moderating. This suggests that there is some slack for Chinese import inflation to rise further without having a major impact on US CPI. In other words, this story could become a problem one day, but that day, if it ever comes, is still a long way in the future. 
Thus the bogeyman is slain, and what is basically going on at the moment should continue to do so, perhaps with the occasional inflation scare — like this one.