Inflation Round-Up

May 18, 2010

A little more than a year has passed since the severest months of the world recession.  Commodity prices are higher now; gold and oil have climbed 31% and 22%, respectively.  But demand-pull price pressures, which typically lag the business cycle, have receded in most economies.  Euro area data exemplify this pattern.  Whereas headline CPI inflation of 1.5% in April was 0.9 percentage points (ppts) higher than a year before, core CPI (excluding unprocessed food and energy) had dropped 1.0 ppts to 0.7%.  Likewise, U.S. CPI inflation in March of 2.3% was 2.7 ppts greater than in the year to March 2009, but core inflation of 1.1% was 0.7 ppts lower than a year earlier.  Japan was nudged — well more like shoved — back into deflation by the recession.  The total Japanese CPI index fell 1.1% in the year to March, 0.8 ppts more than in the prior statement year.  Japanese consumer prices excluding seasonal foods and energy had identical readings to the headline index, a drop of 1.1% in the year to March 2010 following a smaller decline of 0.3% in the year to March 2009.  Canadian CPI inflation of 1.4% in March was 0.2 ppts higher than a year before, while core CPI of 1.7% was 0.3 ppts lower.  Australian consumer prices increased 2.9% in the year to 1Q10, 0.4 ppts more than in the year to 1Q09, but core declined by 1.1 ppts to 3.1%.

Not every advanced economy conformed to this pattern.  British consumer prices increased 3.7% in the year to April, a 17-month high and 1.4 ppts greater than inflation in the prior twelve months.  Core inflation meanwhile doubled from 1.6% in April 2009 to 3.1% last month.  Swiss inflation swung from minus 0.3% in the year to April 2009 to +1.4% in the following twelve months.

Developing and emerging economies show considerable variation in inflation movements between a year ago and the present.   Turkish CPI inflation rose 4.1 ppts to 10.2%, while Russian inflation slowed 7.0 ppts to 6.1%.  South African inflation also has dropped considerably to 5.1% from 8.5%.  In Latin America, inflation eased 1.9 ppts to 4.3% in Mexico and 3.6 ppts to 0.9% in Chile but slipped only 0.2 ppts on balance to 5.3% in Brazil.  Chinese inflation has swung upward by 4.3 ppts over the past year to +2.8% from minus 1.5%. 

A major threat of excessive sovereign deficits to be funded is that they will be eventually bank-rolled by money creation and prove inflationary.  Nonetheless, near-term inflation prospects are pretty subdued because most countries have plenty of slack among productive resources especially among advanced economies.  In those places like Britain where inflation is currently too high, officials blame present levels on temporary factors and are counting on under-utilized resources to keep inflation tolerably subdued.  Indications of expected inflation in most regions do not reflect a significantly upward reassessment because of the sovereign debt crisis.

A theory of foreign exchange rate determination known as purchasing power parity theory (PPP) maintains that exchange rate relationships adjust in the long term to offset disparities of internal rates of inflation between economies.  High U.S. and British inflation in the 1970s was indeed a main reason for the debasement of the dollar and sterling in those periods.  Over the last generation, however, inflation everywhere has been low relative to the earlier era, and differentials between the United States and elsewhere have not been sufficiently meaningful to drive currency markets.

The area where the lessons of PPP theory can still be observed is within the euro area.  Centrifugal strains in the monetary union resulted from chronically lower inflation in Germany than in Greece, Portugal, or Spain, which over the years gave Germany a huge competitive advantage over its neighbors.  German consumer price in the two years between April 2008 and April 2010 rose 1.8%, less than comparable increases of 2.9% in France and 2.8% in Italy and much less than a rise of 5.9% in Greece.  External imbalances within Euroland are wide, raising doubts about their sustainability.  It’s somewhat reminiscent of what happened to the United States in the late 1960s when the dollar was fixed against other currencies.  Shifting to a floating dollar in March 1973 created a mechanism that subjected trends in relative competitiveness to two-sided risk.  The new international monetary system was hardly optimal from the standpoint of promoting full employment and price stability, but it permitted a path of lesser resistance and allowed markets to function without an endless drift away from equilibrium.

We are reminded often these days that the December 1991 Maastricht Treaty upon which Europe’s common currency is based has no provision for governments to leave or be expelled permanently.  Fixed dollar exchange rates in the 1950s and 1960s were similarly based an a formal agreement, the Bretton Woods Accord of 1944, which did not provide a means for abandoning the framework it envisaged. The lack of a dissolution clause governing Euroland doesn’t mean that a partial break-up of the euro can never happen.  The test is whether the arrangement’s costs for any country remaining in the currency union remain lower than the costs of leaving the group.  If the will is strong enough, a way can always be found to change.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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