INFLATION : A HIGH PRICE TO PAY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Inflation: A high price to pay

By Robin Harding and Chris Giles

Published: January 10 2011 20:08

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A strange thing happened in July 2008, during that phoney war between the fall of Bear Stearns in January and the true cataclysm of Lehman Brothers in September. The European Central Bank raised interest rates.

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It did so in spite of the fact – although it was not yet obvious – that the eurozone was already in recession. “Inflation in the euro area has risen further and, in the wake of renewed sharp commodity price increases, arrived at the worrying levels of around 4 per cent in mid-2008,” said Jean-Claude Trichet, ECB president.

Although 2008 is remembered as the year of the financial crisis, it was also the year of an inflation scare that peaked in the summer as average consumer price rises in advanced economies approached 4.5 per cent – and the rate in the emerging world was double that. Oil hit $147 a barrel; food riots broke out.
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Now, nearly three years after the last global scare, policymakers are again grappling to find the best response to a surge in global food and commodity prices. Inflation is back.
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At the end of last year, Brazil faced its highest inflation rate for six years, at 7.6 per cent. Indian equities sputtered last week as fears grew over the price trajectory of staple products such as onions. The subject tops the list of priorities in Beijing.
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In advanced economies, inflation has been more muted because household spending is not so much about food – but indicators have also been rising. Eurozone inflation rose above the ECB’s 2 per cent target in December to 2.2 per cent and price rises are running at 3.3 per cent in the UK. If 2011 is starting to look like it could be a rerun of 2008, that poses one of the single greatest risks to the world economy this year.
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Mr Trichet said on Monday: “This is no time for complacency and the solid anchoring of inflation expectations is considered something that is important by all of us.”
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The ultimate cure for the 2008 inflation shock was a financial and economic crisis in advanced economies that briefly threatened a global depression. Since no one wants a repeat of that, ideas on how best to bring global prices under control without undermining global revival are at a premium. The result is a policy dilemma for central banks that has no easy answer, and maybe no happy answer at all.
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Acting against inflation by raising interest rates might cause another economic rout, while remaining relaxed about price pressures risks a return to the high inflation of a generation ago.
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Two nations divided by a common economic plight
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With some fearing that inflation might be on a 1970s-style persistent march higher, and others that current price rises are masking a 1990s-style Japanese deflation and debt trap where prices fall and debts rise compared with income, central banks have their work cut out. Either would require painful medicine to purge from the system.
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No countries highlight the policy perils more starkly than the US and the UK, where similar economic forces are combining with very different inflation rates.
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Rapidly rising food, clothes and footwear prices late last year pushed up UK inflation, which has now exceeded the Bank of England’s 2 per cent target for 40 of the past 49 months. David Cameron, prime minister, at the weekend described UK inflation figures as “concerning because they’re well outside what the Bank of England is meant to deliver”.
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Worse for the Bank is that its inflation forecasts have been far too optimistic. As recently as last February, the rate-setting monetary policy committee thought inflation at the end of 2010 would be 1.5 per cent. Economists have thus begun to question the independent central bank’s credibility in battling price rises.
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Michael Saunders, of Citigroup, says the MPC’s members “perhaps reluctantly are likely to have to shift focus, from an all-out emphasis on stimulus to a greater emphasis on keeping inflation on target and showing they take the inflation target seriously”.
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In contrast, the greater fear in the US remains that of deflation, which could plunge the world’s biggest economy into a Japan-style economic morass. Prices are not yet falling outright but headline inflation is low: the price index for personal consumption expenditures, the Federal Reserve’s preferred measure, was up by only 1 per cent on a year ago in November. Core inflation, excluding food and energy, rose by 0.8 per cent and the trend is still down.

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America’s high unemployment rate – at 9.4 per cent compared with less than 8 per cent in the UK – creates what economists call an “output gap” between the level of production and the amount a country could produce at full employment. The threat that this gap could drag inflation into negative territory was an important reason why the Fed in November launched another $600bn round of quantitative easing, a way of pumping money into the economy. “Large output gaps do seem to translate into declining inflation at least for some period,” says Jeffrey Fuhrer, senior policy adviser at the Federal Reserve Bank of Boston. “That being the case, one should be cautious about being too confident that inflation will plateau [and not fall further].”
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The immeasurable in pursuit of the unpredictable
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The first question in both countries is how large the output gap is and how effective it is likely to be in moderating inflation. In theory, idle factories and unemployed workers should push prices down, as they compete for such demand as there is in the economy.
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Mr Fuhrer and many other leading experts on US inflation dynamics are sure the output gap – which cannot be measured directly – is large and important. They are reluctant to predict that the US can avoid further drops in inflation.
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James Stock, professor of economics at Harvard University and co-author of an influential paper on inflation presented at the Fed’s Jackson Hole conference last August, says that the historical tendency of inflation to decline when the output gap is very large means that inflation may continue to fall.
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“My best guess is that inflation won’t actually go below zero, it’ll plateau out somewhere very low, with some risk of actual deflation,” says Prof Stock.
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In the UK, where inflation has been persistently high, there is increasing concern that the standard output gap argument might not apply. Andrew Sentance, the most hawkish member of the MPC, worries that spare capacity might either be low or less effective than normal in moderating inflation. “There was little evidence to suggest that spare capacity was exerting significant downward pressure on UK inflation,” he argued at the committee’s December meeting.
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That said, the majority on the committee still agree with their US counterparts that inflation will fall in due course, because high unemployment will act as a damper. But the argument is turning heated. Adam Posen, the most dovish MPC member, countered Mr Sentance with a sarcasm-peppered speech likening those who believe inflation will remain high with deniers of climate change.
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“Yes, it is possible that UK supply capacity disappeared despite relatively low increases in unemployment and liquidations ... It is also possible that our recent snows mean that global warming is not happening, and recent performance in matches mean that [football underdogs] Newcastle will win the Premiership,” he said.
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The self-fulfilling nature of great expectations
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Although the weight of expert opinion sides with those expecting spare capacity to put downward pressure on inflation, both in the US and the UK, the second theoretical argument is altogether more difficult.
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Economists have long thought inflation is a self-fulfilling prophesy. If households and companies expect prices to rise at about 2 per cent a year, they are likely to set wage demands and their prices accordingly. A credible inflation target therefore acts like a magnet, pulling actual inflation towards the target.
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Things can go wrong with the magnet, however. High inflation becomes embedded in the system and can be difficult to reduce. It is even more difficult to emerge from deflation: if everyone expects prices to fall year-on-year, and the falling prices add to the burden of debt, people grow even less willing to spend, sending prices falling further.
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In the UK, the run of upward shocks to price levels, such as this month’s rise in value added tax to 20 per cent, has raised expectations for the level of short-term inflation. The Bank of England is acutely aware of the risk that the public or the markets might lose faith in its argument that inflation is only temporarily high and will fall. A fear that the Bank’s credibility was being lost was evident in the minutes of the December MPC meeting, where the majority argued that “the accumulation of news over recent months had probably shifted the balance of risks to inflation in the medium term upwards”.
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In the US, most of the fear about expectations becoming dislodged go in the opposite direction. While expectations of inflation there still remain close to the Fed’s goal of about 2 per cent, there is an element of doubt about how effective the magnet really is in pulling inflation back up to target. “It does seem that there’s some fragility to this argument. Inflation tracks expectations but expectations track inflation,” says Mr Stock.
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Some of Mr Fuhrer’s recent work suggests that expectations of what inflation will do in the short term may matter more than abstract confidence that the central bank will eventually get it back to target.
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If Mr Stock and Mr Fuhrer are right and inflation does continue to drift down in the US, it may yet mean that there are calls for a further Fed stimulus beyond the planned $600bn. But the rise in food and oil prices is likely soon to send headline inflation higher. Brent crude rose on Monday above $95 a barrel, more than $20 higher than the price in summer.
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A scenario that greatly concerns Fed officials is a spike to well above $100, which would cause headline inflation to rise far above core inflation. Then, the dilemma would be acute.
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The Fed generally remains sanguine about high oil prices because most estimates show that in recent years rises in oil prices – and those of other commodities – have had little effect on other prices.
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There is a one-off rise in headline inflation and that is that. “Passthrough to core seems to be remarkably small” for the US, says Mr Stock.
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“All of these sorts of things have had a small effect on inflation in the last 20 years, particularly for changing energy prices.”
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That evidence is why the Fed concentrates on core inflation and could ignore a spike in oil prices. But even this reasoning is far from foolproof, because rapid growth in emerging markets is generating controlled core inflation through cheap imports and causing oil prices to rise.
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Most central banks would like to concentrate on spare capacity and continue to encourage the recovery, but they have to be wary that they do not accommodate price rises as their counterparts did in the 1970s. They also have to remember that their economies might still emulate the lost decade in Japan.
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Central banks always walk a narrow path, with a fall into excess inflation on one side and a drop towards high unemployment on the other. In 2011 the danger is that there is no path that can safely avoid them both.
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Commodity costs
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Global food prices have reached a nominal all-time high, surpassing the peak seen in 2007-08 – when bread riots rocked poor countries.
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Agricultural commodity prices have surged following a series of crop failures caused by bad weather. That was aggravated when producers such as Russia and Ukraine imposed export restrictions, prompting hoarding by importers in the Middle East and north Africa. The weakness of the dollar, in which most food commodities are denominated, has also contributed.
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Abdolreza Abbassian, senior economist at the UN’s Food and Agriculture Organisation in Rome, describes the situation as alarming and adds: “It would be foolish to assume this is the peak.”
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Other officials, traders and analysts agree, saying that the price of commodities such as corn and wheat could surge even further. In particular, officials and traders are concerned about La Niña, the weather phenomenon that usually brings dryness to the crucial growing areas of Argentina, Brazil and the US. Rising prices of both oil – Brent crude is approaching $100 a barrel for the first time in two years – and coal will add to inflationary pressures.
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The impact of rising food prices on inflation varies widely with location. In the US and Europe, food accounts for as little as 10-15 per cent of a family’s regular shopping – hence its weight on measures such as the consumer price index is relatively small. But in countries such as India, Russia and China, it comprises up to 50 per cent. In the poorest African nations it occasionally exceeds 75 per cent.
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Yet the increase will hit developed economies, too, with companies such as McDonald’s and Kraft raising retail prices.
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The spike is particularly worrying because the impact of food price inflation usually goes beyond its weight in official inflation measures. Analysts say rapid rises in the price of staples such as bread have a broader psychological effect on consumers, who tend to associate these with wider increases in inflation. As such, a jump in food prices could push up long-term inflation expectations.

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Copyright The Financial Times Limited 2011.