Stephen King: Inflation catches banks in a cleft stick
Monday 28 April 2008
Students of economic developments in the 1970s and 1980s know all too well that the central bank par excellence during those two decades was Germany's Bundesbank. Its reputation in safeguarding the value of its currency, the Deutschmark, was second-to-none. Price stability, year-in, year-out, was supposedly its party trick.
It was, though, no more than a myth. By today's standards, the Bundesbank was rubbish at controlling inflation. In the 1970s, West German inflation averaged 5.1 per cent a year. The Bundesbank did better in the 1980s, managing to bring inflation down to an annual average of 2.6 per cent. Best practice nowadays, though, demands an inflation rate of around 2 per cent or lower.
Why then, is the Bundesbank regarded with such reverence? The answer is that Germany's central bank in the 1970s and 1980s did better than others. Inflation wasn't particularly low in Germany, but Germany enjoyed a much lower inflation rate than its peers. US inflation averaged 7.8 per cent a year in the 1970s while the UK's inflation rate averaged a whopping 13.8 per cent. Even in the most difficult of times, then, the Bundesbank remained "best in class".
This, in turn, provides considerable food for thought. The Bundesbank did well given the global inflationary pressures that built up in the 1970s but not well enough by today's standards. Suppose, though, that the Bundesbank had been obliged in the 1970s to use today's inflation targeting regimes. How much more would it have needed to tighten monetary policy to bring inflation down to below 2 per cent? And what would the consequences have been for output and employment?
The one-word answer to this last question is, I suspect, "disastrous". German inflation was low by international standards, but the global inflationary backdrop made it near enough impossible for the Bundesbank to achieve its ultimate objective of price stability. The lesson from the 1970s is, surely, that even the best of central banks can fall victim to difficult international circumstances.
Are we about to see a repeat of this problem? Until now, the answer seemed to be "no", because all central banks were, supposedly, committed to the achievement of price stability. That, though, no longer seems to be true. In particular, inflation is rising rapidly in the emerging world. Chinese inflation is above 8 per cent, Russian inflation is above 12 per cent and, as of the end of last week, Vietnamese inflation was at 21 per cent.
A couple of decades ago, the emerging markets didn't have much of a role to play in the overall trajectory of the global economy. They were simply too small. Today, though, their economies are, in aggregate, almost as big as the United States. As a result, higher inflation in the emerging markets matters for us all.
The most obvious channel through which the emerging market influence is being felt is food and energy prices. Energy prices have been high for many a year now. Food prices have, more recently, started to catch up.
This creates a significant problem. In the UK, for example, the Bank of England is struggling to work out how to deal with ballooning of price increases which reflect global, rather than domestic, developments. The Federal Reserve and European Central Bank face the same challenge. Nowadays, global inflation is made in the emerging world. Their mistakes, you might say, but our problem.
Why is emerging market inflation so high? Most emerging market central bankers would doubtless argue that it's to do with food and energy prices which are typically regarded by the central banking community as "mean reverting" – what goes up one year must come down the next.
That, though, hasn't been true in recent years. I'd argue, instead, that emerging markets have staged a "partial decoupling" from the developed world. Their economies are strong and, in particular, they haven't suffered from any sub-prime nonsense. Yet, for the most part, they force their exchange rates to move in tandem with the US dollar.
In effect, then, they're importing US monetary policy in a situation where they do not require the stimulus stemming from the interest rate cuts currently being delivered by the Federal Reserve. The net result is surging demand, higher inflation pressures and, in consequence, higher global food and energy prices.
This creates a huge dilemma for western central banks. On their own, the sub-prime crisis, the credit crunch and the threat of recession suggest that interest rates should fall. Yet the rise in food and energy prices suggests that rates should rise. What should central banks do?
Judging by the latest published vote from the Bank of England's Monetary Policy Committee, the answer seems to be to disagree. At the last Committee meeting, David Blanchflower voted for a half per cent reduction in interest rates, most others voted for a quarter point reduction but Messrs Besley and Sentance voted to leave rates unchanged.
This debate is hardly surprising. Economic models typically suggest that inflation is influenced mostly by the amount of spare capacity in the domestic economy. If the economy slows down and, in the process, creates more spare capacity, it's natural to assume that inflationary pressures also will fade. What happens, though, if inflationary pressures are stemming from another source?
This, of course, is precisely the dilemma the Bundesbank faced in the 1970s. While German inflation back then was partly a reflection of the domestic economic cycle, the biggest problems stemmed from global developments beyond the Bundesbank's direct influence.
The control of inflation depends, ultimately, on teamwork. All members of the global central banking community need to agree on the need to deliver price stability. If some choose not to, the chances of others delivering on that goal are substantially reduced. That, in my view, is what we're seeing today. Many emerging markets have chosen to direct monetary policy at the maximisation of growth rather than the minimisation of inflation. In the process, they've unleashed a global inflation threat which is leaking into higher prices all round.
This process provides a huge challenge to today's inflation targeting regimes. The more that imported inflation picks up, the greater the required deflation domestically to ensure that the price stability goal is delivered. If, for example, the Bank of England is to ensure inflation over the medium term of around 2 per cent, it may be unable to cut interest rates sufficiently far to head off a major housing crisis.
Developments in the emerging world are, in other words, seriously impeding the ability of Western central banks to deal with the credit crunch. In turn, this leaves policymakers in the UK and elsewhere with some tough choices. Do they stick aggressively to existing inflation targets knowing that, by doing so, there's the danger of a major domestic collapse? Or do they, instead, allow inflation to drift higher? The 1970s Bundesbank, despite its fearsome reputation, chose the latter. Will our current crop of central bankers be any tougher? Don't bank on it.
Stephen King is managing director of economics at HSBC
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