PARSING PRICES : INFLATION AROUND THE WORLD / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

Inflation around the world

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Parsing prices

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Rising inflation is not as worrisome as it appears, at least for now

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Feb 3rd 2011 | from PRINT EDITION

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INFLATION is back. Despite a weak recovery in much of the world, the threat of rising prices preoccupies policymakers and the public. Concerns are greatest in emerging markets. Inflation stands at 4.6% in China and 5.9% in Brazil; in India it is almost 10%, if below last year’s high. But it is on the rich world’s agenda, too (see chart).

Euro-area inflation hit 2.4% in January, according to data out this week. Jean-Claude Trichet, the president of the European Central Bank, has been talking tough, recalling the ECB’s July 2008 rate rise when concern over inflation trumped a wobbling economy. In Britain inflation has been above its 2% target since December 2009 and stood at 3.7% in December. Mervyn King, the governor of the Bank of England, gave warning in January that it will soon climb to 4-5%. Even in America, where inflation has been at historic lows, it jumped to 1.5% at the end of last year.

Much of the surge in inflation reflects dearer commodities. As well as oil and food, metals prices have been soaring: the price of copper hit a series of record highs this week. More expensive raw materials will work their way through the supply chain over the coming months, pushing up on inflation. Another part of the story in Europe is the effort to plug fiscal gaps by increasing VAT, a consumption tax. A hike in VAT at the start of the year will have driven prices higher in Britain in January.

A rise in commodity prices or taxes has only a temporary effect on inflation, however, with the price rise dropping out of annual comparisons after a year. The stuff of nightmares for central bankers is that this leads to a more pernicious type of inflation. Price rises change expectations of inflation, leading workers to bid for wage increases that preserve their buying power and firms to push through price increases, generating a vicious spiral.

These “second-round effects” are worth losing sleep over, but only when there is already inflationary pressure in the wider economy, from a tight labour market and firms running factories at full pelt. Such overheating seems some way off for advanced economies. The unemployment rate is in double digits in the euro area, above 9% in America and 7.9% in Britain. Wage growth has been weak, running below 1% in the euro zone and at around 2% in America and Britain.

Inflation expectations have edged up a little in recent months. But even if workers expected inflation to let rip, they would be in a bind. Karen Ward of HSBC reckons anxious employees won’t ask for more pay for fear that they will end up getting the sack instead.

Rich-world economies are also running well below capacity. According to the OECD, in 2010 the G7 economies were anywhere between 2.4% (Japan) and 4.7% (Italy) below potential output. Such estimates are notoriously imprecise. But if the recovery had already eliminated excess capacity they would be in the wrong city, not just the wrong ballpark.

The story is very different in emerging economies. Many of these got back to their pre-crisis levels of output in 2009. With capacity constraints starting to bite, underlying inflation is on the up. Households’ inflation expectations are also rising. In China they are at their highest for over a decade and there are signs of growing wage pressure.

Higher wages are not, by themselves, a bad thing, especially in a country like China where pay has for years failed to keep pace with rapid productivity growth. The danger comes when loose monetary conditions and an overheating economy mean prices and wages chase each other upward.

To prevent that, central bankers have been fighting back with higher interest rates and higher reserve requirements. The Brazilian and Indian central banks raised rates last month; in total, they have now hiked their policy rates by 2.5 and 1.75 percentage points respectively. China’s central bank recently raised reserve requirements for the seventh time in a year.

For all that, monetary conditions remain extraordinarily loose. According to JPMorgan Chase, real policy rates in emerging economies—the official interest rate minus core consumer-price inflation—are at their lowest level since 2000.

Core consumer-price inflation (which excludes food and energy prices) remains below its 2008 levels. But vigilance is needed. A continuation of booming growth and cheap money will cause trouble in the end.