There is a nice little post at VoxEU, “(At least) Three simple reasons to fear inflation,” by Tommaso Monacelli, Associate Professor of Economics at Università Bocconi, Milan.
While the entire article is worth reading, I thought his discussion of the interaction between growth and inflation was particulalry useful:
In the plethora of comments on the effects of the current financial/credit shock, there seems to be a bit of confusion on its likely inflationary consequences. For instance, a commonly heard criticism to the ECB runs as follows: why worry so much about inflation? If indeed we are entering a recession, it will be the economic slowdown as such to ensure that inflationary pressures remain contained. Hence it would be preferable to do as much as possible to support the already weak growth in Europe. Seen from a different perspective: the financial shock we are facing is intrinsically deflationary.
This argument may prove fallacious, for at least two reasons. The first is well-known: not accepting a moderate slowdown today may induce an inflationary spiral that will require a radical change of direction of monetary policy in the future, with potentially very painful consequences for the real economy. To understand the second argument, it is necessary to recall the Phillips curve. According to this concept, current inflation depends on: (i) inflation expectations for the future; and (ii) the deviation of output from its potential level, i.e., the output gap. What is potential output? It is the level of output that an economy can achieve when prices and wages adjust in a perfectly flexible way to clear markets. Essentially, it is the level of output at which an economy tends to be on average. Potential output, however, is not immutable. It responds to structural changes in the degree of competitiveness of goods, labour and financial markets.
Both in the US and in the Euro Area, however, it is not yet clear whether the type of financial shock we are currently facing will ultimately have a negative impact on potential, rather than cyclical, output. In other words, it is uncertain whether this is a shock that may affect the degree of efficiency of our financial markets. If that were the case, that same shock may produce an upward, rather downward, pressure on the output gap. We would then be faced with an inflationary, rather than a deflationary shock, with the implication that this would require interest rates to rise rather than fall. Are European governments prepared for such a contractionary policy scenario?
It is instructive to recall the lesson of the 1970s. Then the fall in potential output was due to a slowdown in the rate of growth of productivity, which central banks largely failed to identify, leading to sometimes completely erroneous measurements of the level of potential output, and subsequently the effects of its changes on inflation. Today we may find ourselves once again faced with a similar problem, let alone the contemporaneous materializing, as then, of an oil shock. Yet another reason to avoid any complacency about inflation.
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When the largest economy in the world has been on an upward trend in debt for over fifty years – witness America’s debt/GDP ratio – it’s impossible to dissociate “potential” from “cyclical” output, because the statistics are not clean; the only ones we have are when debt is trending upward.
While I think this argument is a step in the right direction, it still fails to address “cost-push inflation” and other relevant factors.
Any nation that exports most of its goods, materials, and energy, is likely to see inflation as the value of its currency falls on the exchange, all other things equal — even if the reason for that fall is a “deflationary” collapse in its financial markets. How counter-intuitive!
Any analysis of the episode of the 70s that ignores cost-push inflation is ascribing far too much influence to the supply/demand endogenous model. This is at best 1/3 of the picture: the other two elements are exchange effects (as noted above) and money/credit quantity.
On that latter point, we have been increasing the money quantity steadily for the past few decades, with benign effect on inflation until recently. That is likely due to “sterilization” of money and credit into the financial economy. When the point of collapse is encountered, we are liable to see much of this already-created money and credit suddenly “spill back out” into the real economy. This would be a “crack up boom” or “flight to real goods” effect and we are arguably already seeing it.
If one were to look around for classical evidence of this sort of effect, one wouldn’t see it: most normal individuals don’t have any wealth to protect. But the real place to look is the world of massive unregulated investment funds (hedge, proprietary trading, sovereign wealth). That is why we are seeing such powerful moves and high volatility.
I think the author is right in worrying about inflation, but like most mainstream economists, his model is woefully limited and outdated. These silly industrial capacity models are quaint, at best.
If the Europeans think inflation is bad now, imagine what happens when investors realize that European central banking is just as bad as US, and the rise of that currency reverses.
Inflation expectations can be very accurately modeled by taking the change in inflation over the past six months and projecting it forward over the next two years.
Which means inflation expectations are nothing other than the experience of inflation.
For example, the current credibility of the Fed in fighting inflation is nothing other than the experience of low inflation. This is the so-called anchor.
The commenter is correct about cost-push inflation being totally outside the current discussion. Why? It can hardly be said that demand is driving up prices.
This comment: “… it is not yet clear whether the type of financial shock we are currently facing will ultimately have a negative impact on potential, rather than cyclical, output. In other words, it is uncertain whether this is a shock that may affect the degree of efficiency of our financial markets. If that were the case, that same shock may produce an upward, rather downward, pressure on the output gap.”
Is nonsense.
Is there significance in the resumption of POMO by the Fed after none taking place for 10 months?
http://www.ny.frb.org/markets/pomo/display/index.cfm?showmore=1
Re: “What is potential output? It is the level of output that an economy can achieve when prices and wages adjust in a perfectly flexible way to clear markets.”
But when wages are essentially frozen (at least for those who produce real goods), and prices keep going up, things seem broken to my economically uneducated self.
mjc
Alan,
Thank you, and I also agree that statement you quoted is gibberish.
In addition, THANK YOU for your point on inflation expectations — this has been a niggle of mine for a while. Inflation expectations are a fantasy inasmuch as they are anything besides people’s experience of recent past inflation.
When Bernanke persistently invokes “inflation expectations” what he’s really doing is hedging: if inflation remains anchored, then the central bank pats itself on the back for a job well done. But if inflation gets out of control, the central bank blames the people for having “inflation expectations”.
Total and utter disingenuous nonsense.
In fact, one can disprove “inflation expectations” with a simple thought experiment. Start with the case where both inflation and inflation expectations are benign and low. Assume that inflation expectations can actually trigger inflation. For this to happen, then, at least someone somewhere must have and act upon an expectation of higher inflation.
If this person is a consumer, they will hoard goods, only to find out that the inflation they expected does not materialize, which leaves them with surplus goods at a lower marginal utility, which they then must liquidate at a loss.
If this person is a producer/retailer, they will raise prices. Since their peers do not yet share their inflation expectations, they will not follow suit, causing the price-raiser to lose a disproportionate amount of business. This quickly puts an end to any “expectations-based” inflation speculation.
Conclusion: inflation leads inflation expectations, not the other way around.
Corollary: inflation is always the fault of central bankers, not the people.
Corollary 2: Bernanke is either superstitious or dishonest.