Some Central Banks Better Prepared for Inflation than Others

April 15, 2011

Evidence of an upturn in inflation continues to mount and can be found in a wide array of economies. 

Take the United States where consumer prices recorded a 12-month 2.7% rate of increase in March, up from 1.7% in November, and advanced at a 6.1% annualized pace between December and March, almost twice the pace in the previous calendar quarter.  Energy is not the only item showing more strain.  Food prices accelerated to a 7.5% annualized advance in 1Q11 from 1.6% in the final quarter of 2010.  The core 12-month rate of inflation has doubled to 1.2% since October, and such picked up to an annualized pace of 2.0% last quarter from 0.8% in 4Q10.

Europe hasn’t been insulated. In the euro area, CPI inflation of 2.7% is now 0.8 percentage points above the ECB target ceiling and has advanced from 1.6% last August, 0.9% in February 2010 and a low point of minus 0.7% in July 2009.  Core inflation jumped 0.4 percentage points in March to 1.5% and is twice the pace of 0.8% in the year to April 2010.  British inflation has been no lower than 3.0% since the start of last year and 4.0% or more throughout the first quarter of 2011, that is twice as high as its target.  Sterling weakness has played a role in this elevation.  German wholesale price inflation averaged 10.4% last quarter.

Among developing countries where food represents a comparatively larger chunk of household spending, China’s 5.4% CPI inflation rate is at a 31-month high and well above 2.9% seen at the midpoint of last year.  Inflation is at 8.8% in India, 6.0% in Brazil, 13.2% in Pakistan, 5.0% in Singapore, and 4.7% in South Korea.

An honest debate among private analysts and officials has raged for some time about the seriousness of inflation.  One school of thought views intensifying price price pressures as the logical and inescapable result of massive monetary easing retained for too long.  Another points to a series of special factors like unrest in the Middle East and weather-induced crop shortages as the main culprit, while arguing that with an abundance of unused capital and labor resources, it will not be possible for wage strains to take root and that bad inflation cannot be sustained without a drum-tight labor market.

Many central banks have been back-pedaling out of ultra-easy monetary policies imposed during the Great Recession.  All the BRIC nations have done so.  In China, reserve requirements were raised nine times in under fourteen months, and key interest rates have undergone four increases of 25 basis points each.  Brazil’s Selic rate is now 300 basis points higher, at 11.75%, than its trough.  The Reserve Bank of India has implemented eight rate increases totaling 200 basis points.  The key Russian interest rate has been lifted just once, but reserve requirements have been boosted nine times.  Rates have climbed ten times by a total of 400 basis points to 4.5% in Chile and nine times by 250 bps in all in Israel.  They have been raised from 1.25% to 4.0% in Peru, from 3.0% to 4.75% in Australia, from 0.25% to 1.0% in Canada, from 0.25% to 1.5% in Sweden, from 1.25% to 2.0% in Norway, from 1.25% to 2.5% in Thailand, from 2.0% to 3.0% in South Korea, from 5.25% to 6.0% in Hungary, from 1.25% to 1.75% in Taiwan, from 3.5% to 4.0% in Poland, from 3.25% to 3.25% in Colombia, from 6.0% to 6.25% in The Philippines, from 6.5% to 6.75% in Indonesia, and perhaps most significantly from 1.0% to 1.25% in the euro area.  While Turkey and Sri Lanka had central bank rate cuts not long ago, the latest policy moves have been to tighten via higher reserve requirements.  The monetary policy of Singapore is run by adjusting the exchange rate rather than interest rates, and the last three administrative shifts in the S-dollar’s parameters have been in the direction of greater restraint.

Only a few central banks have not yet begun to tighten policy or, as many officials prefer to say, normalize policy.  Conspicuous on this short list are the Federal Reserve Bank of England and Bank of Japan, and the club also includes central banks in Switzerland, Iceland, the Czech Republic, Malaysia, South Africa and New Zealand.  The Reserve Bank of New Zealand had actually tightened twice before its earthquakes but cut the interest rate back to its 2.5% record low subsequently.  The Bank of Japan is another special case as Japan’s economy reels from the Sendai earthquake.  Hawkish rhetoric suggest that central banks in Malaysia and South Africa are nearing a rate increase.  Icelandic and Romanian rate policies are in a pausing phase that feels like a floor.  Swiss inflation is very low at 1.0%, and if the 0.25% rate there were to persist, officials do not project a return to 2% or higher inflation until the third quarter of 2.1%. 

The status quo maintained by Federal Reserve and Bank of England cannot be easily explained or justified, and that puts the dollar and sterling in jeopardy.  Those currencies are endangered not merely because most other monetary tightening trains have left the station.  First, officials at both central banks have taken their policy disputes into the public arena.  It’s unnerving to see policymakers disagree.  For another thing, Britain and the United States have a legacy of relatively high inflation at times of inclining world inflation.  A third factor that sets the United States and Britain apart is that they also have significantly chronic current account and fiscal deficits.  The U.S. and British external imbalance are likely to run above 3% of GDP and around 1.5% of GDP, respectively, while their fiscal deficits will both likely lie in a 9-10% of GDP range.  A recipe of ignored inflation, unpredictable monetary policy, and twin deficits has historically been a bad combination for currencies, particularly for ones, like the dollar and sterling, where offshore holdings of the currency are huge.

A big problem with forecasting a weaker dollar is that the euro area has its own major structural problem.  The Greek-German ten-year bond spread reached 10 percentage points today.  So whose problem is most serious?  The euro’s 22.2% rise from $1.1878 last June 7 to a high of $1.4520 this past week suggests the dollar.  When all the risks are weighed, investors want to be in a currency whose central bank cares deeply about preserving low domestic inflation and a stable external value.  Confidence exudes that the European Central Bank fits that description better than the Federal Reserve or the Bank of England.  While U.S. growth prospects are better than those of the euro area as a whole, they are not as good as Euroland’s largest pieces.  Even if it is the karma of the common European currency to break up, the legacy of the ECB and Bundesbank will be portable to those stellar pieces that now inhabit the euro.

A separate problem is that the dollar is already very weak.  Investors don’t buy an asset per se.  They shop for an attractive price, and the lower that price goes according to textbook theory, the more appealing it becomes to purchase, all other considerations being the same.  In practice, currency markets have a large herd component and thus tend to overshootIn the absence of complaints by U.S. officials about dollar depreciation, one doesn’t sense that the dollar is presently too weak to fall.  On the contrary, many investors no doubt feel that a weaker dollar to spur exports has been an explicit goal of quantitative easing by the Federal Reserve.  The Bank of Japan responded to a record low in dollar/yen with intervention.  The ECB raised interest rates earlier this month even though the D-mark translation value of the euro is now very near to the German currency’s strongest pre-1999 level of 1.3450 per dollar reached in March 1995, while the Fed thus far refuses abandon its rate guidance that exceptionally low central bank rates are probable for an extended period further. 

Sterling has more than held its own against the dollar, trading persistently above $1.60, roughly 15% above its 2010 low, and very close to its 20-year average of $1.6549.  Against the euro, however, sterling remains 25% below its central D-mark parity when it is part of the European Exchange Rate Mechanism from October 1990 to mid-September 1992.  In the medium term, sterling’s fate will hinge on whether economic recovery can tolerate the chosen path of extreme fiscal austerity, whether the government can indeed deliver impressive reductions in its deficit, and whether monetary officials are tempted in the meantime to permit sterling depreciation as a counterweight to tighter fiscal policy.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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