The ex­ag­ger­ated death of in­fla­tion

Financial Mirror (Cyprus) - - FRONT PAGE -

Is the era of high in­fla­tion gone for­ever? In a world of slow growth, high debt, and tremen­dous dis­tri­bu­tional pres­sures, whether in­fla­tion is dead or merely dor­mant is an im­por­tant ques­tion. Yes, mas­sive in­sti­tu­tional im­prove­ments con­cern­ing cen­tral banks have cre­ated for­mi­da­ble bar­ri­ers to high in­fla­tion. But a sig­nif­i­cant part of a cen­tral bank’s cred­i­bil­ity ul­ti­mately de­rives from the broader macroe­co­nomic en­vi­ron­ment in which it op­er­ates.

In the first half of the 1990s, an­nual in­fla­tion av­er­aged 40% in Africa, 230% in Latin Amer­ica, and 360% in the tran­si­tion economies of East­ern Europe. And, in the early 1980s, ad­vanced-econ­omy in­fla­tion av­er­aged nearly 10%. To­day, high in­fla­tion seems so re­mote that many an­a­lysts treat it as lit­tle more than a the­o­ret­i­cal cu­rios­ity.

They are wrong to do so. No mat­ter how much cen­tral banks may wish to present the level of in­fla­tion as a mere tech­no­cratic decision, it is ul­ti­mately a so­cial choice. And some of the very pres­sures that helped to con­tain in­fla­tion for the past two decades have been re­treat­ing.

In the years pre­ced­ing the fi­nan­cial cri­sis, in­creas­ing glob­al­i­sa­tion and tech­no­log­i­cal ad­vances made it much eas­ier for cen­tral banks to de­liver both solid growth and low in­fla­tion. This was not the case in the 1970s, when stag­nat­ing pro­duc­tiv­ity and ris­ing com­mod­ity prices turned cen­tral bankers into scape­goats, not he­roes.

True, back then, mon­e­tary au­thor­i­ties were work­ing with old-fash­ioned Key­ne­sian macroe­co­nomic mod­els, which en­cour­aged the delu­sion that mon­e­tary pol­icy could in­def­i­nitely boost the econ­omy with low in­fla­tion and low in­ter­est rates. Cen­tral bankers to­day are no longer so naive, and the pub­lic is bet­ter in­formed. But a coun­try’s longterm in­fla­tion rate is still the out­come of po­lit­i­cal choices not tech­no­cratic de­ci­sions. As the choices be­come more dif­fi­cult, the risk to price sta­bil­ity grows.

A quick tour of emerg­ing mar­kets re­veals that in­fla­tion is far from dead. Ac­cord­ing to the In­ter­na­tional Mon­e­tary Fund’s April 2014 World Eco­nomic Out­look, in­fla­tion in 2013 reached 6.2% in Brazil, 6.4% in In­done­sia, 6.6% in Viet­nam, 6.8% in Rus­sia, 7.5% in Turkey, 8.5% in Nige­ria, 9.5% in In­dia, 10.6% in Ar­gentina, and a whop­ping 40.7% in Venezuela. Th­ese lev­els may be a big im­prove­ment from the early 1990s, but they cer­tainly are not ev­i­dence of in­fla­tion’s demise.

Yes, ad­vanced economies are in a very dif­fer­ent po­si­tion to­day, but they are hardly im­mune. Many of the same pun­dits who never imag­ined that ad­vanced economies could have mas­sive fi­nan­cial crises are now sure that ad­vanced economies can never have in­fla­tion crises.

More fun­da­men­tally, where, ex­actly, does one draw the line be­tween ad­vanced economies and emerg­ing mar­kets? The eu­ro­zone, for ex­am­ple, is a blur. Imag­ine that there was no euro and that the south­ern coun­tries had re­tained their own cur­ren­cies – Italy with the lira, Spain with the pe­seta, Greece with the drachma, and so on. Would th­ese coun­tries to­day have an in­fla­tion pro­file more like the United States and Ger­many or more like Brazil and Turkey?

Most likely, they would be some­where in be­tween. The Euro­pean pe­riph­ery would have ben­e­fited from the same in­sti­tu­tional ad­vances in cen­tral bank­ing as ev­ery­one else; but there is no par­tic­u­lar rea­son to sup­pose that its po­lit­i­cal struc­tures would have evolved in a rad­i­cally dif­fer­ent way. The pub­lic in the south­ern coun­tries em­braced the euro pre­cisely be­cause the north­ern coun­tries’ com­mit­ment to price sta­bil­ity gave them a cur­rency with enor­mous anti-in­fla­tion cred­i­bil­ity.

As it turned out, the euro was not quite the free lunch that it seemed to be. The gain in in­fla­tion cred­i­bil­ity was off­set by weak debt cred­i­bil­ity. If the Euro­pean pe­riph­ery coun­tries had their own cur­ren­cies, it is likely that debt prob­lems would morph right back into el­e­vated in­fla­tion.

I am not ar­gu­ing that in­fla­tion will re­turn any­time soon in safe-haven economies such as the US or Ja­pan. Though US labour mar­kets are tight­en­ing, and the new Fed chair has em­phat­i­cally em­pha­sised the im­por­tance of max­i­mum em­ploy­ment, there is still lit­tle risk of high in­fla­tion in the near fu­ture.

Still, over the longer run, there is no guar­an­tee that any cen­tral bank will be able to hold the line in the face of ad­verse shocks such as con­tin­u­ing slow pro­duc­tiv­ity growth, high debt lev­els, and pres­sure to re­duce in­equal­ity through gov­ern­ment trans­fers. The risk would be par­tic­u­larly high in the event of other ma­jor shocks – say, a gen­eral rise in global real in­ter­est rates. Recog­nis­ing that in­fla­tion is only dor­mant ren­ders fool­ish the oft-stated claim that any coun­try with a flex­i­ble ex­change rate has noth­ing to fear from high debt, as long as debt is is­sued in its own cur­rency.

Imag­ine again that Italy had its own cur­rency in­stead of the euro. Cer­tainly, the coun­try would have much less to fear from an overnight run on debt.

Nev­er­the­less, given the huge gov­er­nance prob­lems that Italy still faces, there is ev­ery chance that its in­fla­tion rate would look more like Brazil’s or Turkey’s, with any debt prob­lems spilling over faster price growth.

Mod­ern cen­tral bank­ing has worked won­ders to bring down in­fla­tion. Ul­ti­mately, how­ever, a cen­tral bank’s anti-in­fla­tion poli­cies can work only within the con­text of a macroe­co­nomic and po­lit­i­cal frame­work that is con­sis­tent with price sta­bil­ity. In­fla­tion may be dor­mant, but it is cer­tainly not dead.

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