The Clear and Present Danger of Inflation

We’re a bit late to a very good comment in today’s Financial Times, “Interest rate cuts will not solve the crisis,” by Wolfgang Munchau.

Munchau argues that despite inflation targeting, the potential to move into an inflationary cycle is greater than many analysts recognize, and that even a small increase in inflation at this juncture would be “toxic.” This piece speaks for itself, so we won’t belabor it further.

From the Financial Times:

Probably the biggest macroeconomic danger the world economy faces over the next two years is a rise in inflation. The problem is not inflation as such, undesirable as it may be, but the wider economic consequences of a rise in inflation under a regime of inflation-targeting central banks. A rise in inflation would trigger global interest rate increases, and this in turn could mark the beginning of a severe global recession.

There are many reasons to believe that this is not going to happen. Inflation forecasts are relatively optimistic. Central bankers also appear to be placing a lot of faith in measures of inflationary expectations, which show that all is well.

But be careful. Just as commercial bankers felt comfortable sitting on AAA-rated subprime debt, central bankers may take false comfort from those measures. A popular market-based measure of inflationary expectations is based on the yield of inflation-indexed bonds, such as Tips in the US or OATei, euro-denominated bonds issued by the French government. If you calculate the difference in yields between inflation-indexed bonds and a corresponding ordinary government bond, you should, in theory, get the rate of inflation that financial markets expect to prevail at the time when the bond is due to be repaid.

There are fundamental and technical problems with this approach. The fundamental one is that financial markets may not be as forward looking as we like. Those apparently forward-looking indicators failed to flag the moderate increases in inflation that took place over the past three years. Inflation expectations started to rise once inflation did – the measures may have told us what we already knew.

The technical problem is the liquidity premium. The market in inflation-protected bonds is less liquid than the market for ordinary government bonds. Hence there is a liquidity premium, which raises their price and depresses their yields, leading to a persistent underestimate of future inflationary expectations.

The success of any indicator lies in its ability to identify turning points. The world economy is currently subject to several simultaneous shocks, whose joint impact is extremely difficult to calculate. One such shock has been the persistent rise in the prices of oil and food. Some central banks, including the US Federal Reserve, target a core inflation measure that excludes both on the grounds that they are volatile. The trouble is that the price movements of oil and food have actually not been volatile at all, but strongly unidirectional. This means that core inflation indicators may persistently underestimate the true rate of inflation. Geopolitical tensions in the Middle East will probably continue to put pressure on the oil price for some time.

Another factor is the changing nature of globalisation. For the past 10 years, globalisation has had a disinflationary impact on the world economy. But we have just made a transition to a mildly inflationary phase, as the newly industrialised countries are getting richer and demanding more goods. In particular, they are consuming more energy and global transportation services.

A third factor is a global monetary overhang after years of double-digit money supply growth in several large countries. This is not a monetarist argument. Money may be a useless indicator for a central bank to target but, over long periods of time, one would expect excessive money supply growth to cause a rise in inflation.

A problem specific to the US and the countries with pegs to the dollar is the persistent weakness in the US currency. There is a fair chance of another substantial fall in the trade-weighted exchange rate of the dollar, which would add to inflation as the price of imported goods rose.

Logic dictates that currency movements cannot be inflationary for the entire world economy. In the eurozone, for example, an ultra-strong currency provides some protection against inflation. But there are strong regional effects that offset this. One is a big structural shift in Germany, the largest eurozone economy. The country has completed its post-unification adjustment process. The double-digit wage demand by train drivers, which gave rise to large-scale local transport strikes last week, is perhaps the clearest sign that the long period of wage moderation is about to end. The economic reform process has already ground to a halt.

You can probably find equally convincing examples that appear to point in the other direction. I am not predicting a huge surge in global inflation, merely that global inflationary pressures will exceed forecasts that tell us that everything will stay the same. The trouble is that even a small rise in inflation could be toxic at a time when the world economy is coping with the collapsing credit bubble, and when global imbalances are beginning to adjust.

In response to the credit crisis, the Fed has already cut interest rates and is expected to cut rates even more. But if central banks cut too aggressively, they may end up compensating with excessively high nominal interest rates later on. It is not difficult to imagine how the highly indebted private sectors in the US or the UK would cope with nominal rates of 7 or 8 per cent, let alone Spain with its hugely exposed property market. A wise central banker should probably err on the side of caution at this juncture, and refrain from cutting rates, or perhaps even raise them moderately now if inflation concerns justify this.