Fear of Inflation

May 13, 2008

Commodity price strains have lifted inflation across a broad cross-section of world economies. A sampling of latest twelve-month inflation rates includes 4.0% in the United States, 3.3% in the euro area, 3.0% in Britain, 8.5% in China, 7.9% in India, 14.1% in Pakistan, 13.3% in Russia, 10.6% in South Africa, 9.6% in Saudi Arabia, 9.0% in Indonesia, 10.7% in Turkey, and 8.8% in Argentina. Even for deflationary Japan, a climb of 1.2% represents a level not seen in ten years (and longer if one excludes the impact of a sales tax hike in 1997).

Each day seems to bring disturbing price news. Today’s batch included U.S. import prices, British consumer prices, and Chinese corporate service prices. In spite of a more stable dollar, U.S. import prices jumped 1.8% m/m last month and showed a 12-month increase of 15.4% compared to 2.1% in the year to April 2007. Non-fuel import prices increased 1.0% m/m for a second straight time and recorded a 5.8% year-over-year gain, nearly double their 3.0% rise in the year to November. The U.K. CPI went up 0.8% m/m in April, much more than the street forecast of 0.5% and enough to produce a 3.0% y/y pace, up from 2.5% in the year to March. The retail price index, which bears a closer relationship to wages than the CPI, registered a 4.2% on-year increase. Chinese corporate goods prices advanced 10.3% y/y last month, a twofold acceleration from 5.1% in the year to May 2007.

Officials and private analysts anticipate a gentle fall-back of inflation over the next 18 months in most economies in lagged response to sub-trend real GDP growth. Crucially, such reasoning depends on anchored inflation expectations. Expected inflation is characterized by considerable inertia. This is a big problem for policymakers who try to halt a significant inflation problem but eases the task of preventing second-order inflation when an exogenous shock strikes an environment of reasonable price stability. In current circumstances, actual inflation has exceeded target for enough time that officials cannot take for granted that expected inflation will stay well-behaved. The longer above-target inflation persists, the greater becomes the risk that expected inflation will drift higher even if policies seem reasonably attentive to the risk of inflation.

Cutting interest rates when inflation is still cresting sends up a red flare. In the Fed’s case, so does easing monetary policy when the dollar is sinking and gold is appreciating. So too do rate cuts amid a rapidly expanding money stock. In the United States, MZM expanded at a 20.7% annualized rate over the last 13 reported weeks. British M4 climbed 11.9% in the year to March, and Euroland M3 increased 11.1% in the year to 1Q. Chinese M1 and M2 grew 19.1% and 16.9%, respectively, in the year to April. Elevated credit demand in the teeth of financial market turbulence and uncertainty explain some of these spikes but not nearly enough to erase a picture of possibly overly accommodative monetary policy. I applaud G7 officials for taking a stand against one-way dollar depreciation. As the dollar’s situation develops, it will be important to demonstrate a readiness to offer more than lip service.

The most encouraging sign that the fight to keep the spike in inflation temporary lies in generally subdued wages despite otherwise outward signs of labor market tightness in many places. The U.K., for instance, reports average earnings tomorrow. Average earnings rose 3.7% y/y in Dec-Feb and are likely to match that pace for 1Q08. Bank of England research suggests that 4.5% represents the threshold above which inflation tends to become entrenched.

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