Expected Inflation in Motion

November 11, 2008

In recent years, central bankers had preached the imperative of anchoring price expectations at a low level. Low inflation is not a sufficient achievement. Equally important, policymakers wish to solidify investor confidence that consistently low inflation will be preserved over the medium term, even if exogenous shocks occasionally bump actual inflation away from the preferred and oftentimes targeted path. 2008 has been a difficult year to implement this goal.

In a fundamental way, central bankers have failed their own test. As the Fed was slashing rates early this year, policymakers elsewhere were wringing their hands over unacceptable upside risks to inflation. As recently as July, the ECB raised its key rates by 25 basis points. Three months later, rates are tumbling downward, and there is talk of deflation, not necessarily from the central banking quarters but in the discourse of market chatter. Such a swing in the pendulum of price expectations suggests that central bankers and private analysts are truly unsure about the interplay of commodity costs, aggregate demand, capacity utilization, and the formation of price expectations. This wasn’t the first time since the outbreak of the Iraq War in which oil prices fell sharply in a compressed space of time. Prices had averaged $74.43 in July 2006 yet dipped under $50 six months later. Commodity price behavior is a fact of life. Seeds of the global recession, which has kicked the stuffing out of inflation, were sown fifteen months ago, and the catalyst for the recent panic, the failure of Lehman Brothers, stemmed from a decision by fiscal policymakers that monetary policymakers should have anticipated. Despite no crystal balls to see the exact evolution of the global economic downturn, the scenario that has unfolded was an identified possibility from a very early stage. It was common knowledge too that the worst historical contractions of economic activity were the ones caused by a functionality problem in the financial sector.

Many central bankers no doubt still believe that inflation would have continued to accelerate upward had a vigilant stand against such forces not been taken and maintained until very late. I beg to differ. In an overly indebted world, the progressively administered climb in short-term interest rates made a great deleveraging a matter of when, not if, and once the process began in the second half of 2007, there was not going to be an easy way to stop the chain reaction. A comparison of projected CPI inflation in 2009 according to monthly surveys of forecasters by The Economist in August and November documents declines from 2.7% to 1.8% in the case of the United States and to 2.0% from 2.6% in Euroland, 0.7% from 1.0% in Japan, and 2.4% from 2.9% in Great Britain. ECB officials now concede that in some months next year, consumer prices could even be lower than their year-earlier levels. Meanwhile, emerging markets are also experiencing a big reversal in price pressures. For example, China reported today CPI inflation of 4.0% in the year to October, down from 7.1% in June and 8.7% last February, and deflation phobia is spreading there, too.

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