INFLATION : GREATER EXPECTATIONS ? / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

Inflation

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Greater expectations?

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Inflation is rising, but worries are overstated

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Feb 3rd 2011 | from PRINT EDITION

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WHEREVER you are reading this article, inflation is probably in the news. Soaring commodity prices are pushing up consumer prices across the globe. The pressure is clearest in fast-growing emerging markets, where people spend a big slice of their incomes on food.


China’s inflation rate is hovering around 5%, Brazil’s is approaching 6% and India’s remains close to 10%. Even in enfeebled rich economies the “I” word is back on the front pages. Britain’s consumer prices rose 3.7% in the year to December. Prices in the euro area rose 2.4% over the past year, above the European Central Bank’s goal of 2% or less.


The big worry is that global monetary conditions are far too loose, thanks both to rock-bottom interest rates and bloated central-bank balance-sheets in the rich world and to emerging economies’ inability, or unwillingness, to tighten policy enough in response. This combination suggests inflation could run out of control if left unchecked. Today’s concerns are manifesting themselves in different ways in different places (see article). In emerging markets, politicians fear social unrest and technocrats fret about economies overheating. Inflation jitters are also rising among some central bankers in rich economies, where deflation until recently seemed the bigger threat. Two members of the Bank of England’s policy committee last month voted for an immediate rise in interest rates. A prominent ECB official says increases in Europe’s imported inflation “cannot be ignored”.


Yet central bankers should not be very alarmed either by the scale or by the dynamics of overall inflation. Inflation is up, but hardly high. In no big economy, emerging or rich, is it at the peaks reached in 2008 (in America it is merely 1.5%). Much of its recent rise is driven by what are clearly one-off factors, from weak Russian harvests that sent grain prices soaring to the rise in value-added tax in Britain. Central bankers should ignore such temporary shocks. Their role is to prevent one-off surges from translating into persistently higher pressure on prices.


So far there is little evidence of that. In America “core” consumer prices, which exclude food and fuel, rose by a modest 0.8% in the year to December. In the euro zone core inflation has recently held steady at 1.1%. Even in booming emerging economies core consumer prices are rising much more slowly than they were in 2008.


Over time, temporary price pressure can become entrenched, through either consumers’ expectations of future inflation or workers’ demands for higher wages. That does not seem likely to happen. In most rich countries, inflation expectations have risen only from very low to low, and high unemployment keeps workers from demanding pay rises. Without higher wages to compensate, rising food and fuel prices will cut into consumer spending—which in turn suggests lower, not higher, inflation down the road. That is especially so in countries such as Britain where fierce fiscal austerity is also set to dampen spending.


Germany may be an exception. With its economy humming, and unemployment falling, German wages may start to accelerate. Unlike their Anglo-Saxon counterparts, German workers might claw back the recent rise in food and fuel.


But that would be good news, not bad. German wages have been squeezed for a decade; faster wage growth would boost domestic demand and help to reorient Germany’s economy. And slightly higher inflation in Germany would make life easier for the indebted peripheral economies of the euro zone, because the cuts in wages and prices needed to make them competitive would be smaller. For both reasons, the ECB should not crack down on inflation.


The tools to use


In emerging economies, it is a different story. Most are racing along, with monetary conditions a lot looser than they were in 2008, posing a real risk of a persistent inflation problem. But even here the dangers can be exaggerated.


China’s rising wages and prices, for instance, should help to rebalance its economy towards domestic spending—the practical equivalent of a stronger currency. Low interest rates in rich economies make life more complicated for policymakers in emerging ones: if emerging-market policymakers raise rates, they attract more foreign capital, fuelling inflation. They can try to keep the cash out through controls on foreign capital, but these are often ineffective.


Far better to slow spending, and thus inflation, with tighter fiscal policy. In India and Brazil the main inflation-fighting tool ought to be a smaller budget deficit.


All this suggests there is little to get in a lather about. Inflation is always a cause for concern. But, today, not for panic.