Where to focus: Growth or Inflation?

June 25, 2008

Each central bank must decide this question for itself.  But as the following empirical evidence demonstrates, accelerating inflation is a more universal problem than deficient economic growth.  On-year consumer price inflation is now running double or nearly so to levels of a year earlier.  Among developed economies, CPI inflation is at 4.2% in the United States (versus 2.7% a year ago), 3.7% in Euroland (up from 1.9%), 2.9% in Switzerland (0.5%), 3.3% in Britain (2.5%), 4.2% in Australia (2.4%) and 0.8% in Japan (0.0%).  In emerging markets, the increases have been to 7.7% from 3.4% in China, 19.3% from 7.4% in Pakistan, 10.9% from 6.4% in South Africa, 10.5% from 2.9% in Saudi Arabia, 19.7% from 10.0% in Egypt, 7.8% from 6.7% in India, 5.6% from 3.2% in Brazil, 4.9% from 2.3% in South Korea and 7.6% from 1.9% in Thailand. 

Latest on-year economic growth rates of 3.1% in Switzerland, 2.5% in both the United States and Britain, 2.2% in Euroland, 3.6% in Australia, and 1.3% in Japan (where growth in 1Q08 reached 4.0% saar) look decent.  Year-over-year growth of 10.6% in China, 8.8% in India, 6.9% in Egypt, 6.0% in Thailand, and 5.8% in both South Korea and Brazil are much better than decent.  To be sure, the momentum of growth is adverse, as the leap in energy and food costs now present as much, if not more, resistance as does intrinsically tight financing conditions.  Euroland posted sub-50 readings in its composite, manufacturing, and service PMI’s for the first time since mid-2003.  The composite PMI is 8.3 points lower than a year ago, and the business expectations component of the services PMI has shed an even larger 9.5 points.  Germany’s IFO index of business conditions and expectations is 5.7 points below its year-ago level and the weakest it’s been in 2-1/2 years.  Belgian business sentiment slumped to -5.9 in the latest reading from -1.6 the month before.  Japan’s all-industry index showed an on-year rise of a minuscule 0.2%, and business sentiment fell to -15.2 in 2Q08, at least a 4-year low, from -9.3 in 1Q according to the latest quarterly survey of Japan’s Ministry of Finance.  Also in Japan, May levels for consumer confidence of 33.9 and the mood of small-firm employees of 32.1 were each very low.  Significant housing corrections persist in the United States, Britain, Spain, and Ireland.

The substantial increases in inflation cast doubt on whether economic slowdowns will anchor expected inflation and return actual inflation to acceptable levels over the medium term.  The more forcefully that policymakers try to mitigate economic weakness, the greater is the likelihood that the current commodity-intensive inflation could spread to other price categories.  The biggest policy blunders of not countering economic weakness, on the other hard, have occurred in recessions where, like the present one, dysfunctional financial markets were central to imploding economic activity.  Policymakers face a formidable challenge.  I believe the area of greatest misjudgment lies in the direction of not sufficiently containing the inflation threat. 



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