Thursday, March 20, 2008

Inflation is back: Propsects for the world economy

The monster of inflation is rearing its head across the world. Except for deflation laden Japan and the EU, inflation is rising everywhere. In the extreme case, it was recorded at 66000% in Zimbawe for 2007. Central Banks across the world are facing the choice between inflation and growth, exports and imports, soft and hard landings.

One school argues that today's rising global inflation is just a temporary aberration, driven by soaring prices for food, fuel, and other commodities. Others argue that for the past two decades, the world economy benefitted from an unusually benign low inflation conditions - spurt in the globalization of production chain and the immediate resultant benefits, cheap East Asian (especially Chinese) imports, massive consumption binge by American consumers, low commodity prices, rising forex reserves and resultant global savings glut, etc. Therefore, they argue, the cyclical inflation has now returned.

Unlike other macroeconomic variables, which are rooted in tangible economic data - production, consumption, savings, investment etc - inflation is considerably dependent on the intangible "expectations" held by producers, investors and consumers, about the future economic climate. The highly volatile global financial markets have added more mystery to the already uncertain economic prospects, especially now with a recession looming large in the world's largest economy. Therefore the fight against inflation cannot be confined to addressing macroeconomic variations or distortions, but involves influencing the minds of the major economic stakeholders. One way to control this is to demonstrate visible Central Bank and Government commitment to keep inflation under control. However, such a monetary policy should not mean the effective enslavement of interest rates to the single point agenda of targetting a fixed inflation rate.

So far, the US Federal Reserve has been aggressively cutting interest rates in the face of a fast deepening credit crisis and recession, brought about by the bursting of the sub-prime mortgage bubble. It does not appear to recognise that the credit squeeze has its roots not in any ordinary liquidity crisis, but in a very deep solvency crisis that is threatening to engulf all the major Wall Street institutions. Easy money and loose monetary policies cannot mandate away such a solvency crisis. Somebody has to pay for the past sins that ran up this crisis.

Economists like Kenneth Rogoff feels that "the price of this “insurance policy” will almost certainly be higher inflation down the road, and perhaps for several years". He also argues that since many countries, peg their currencies to the dollar, formally or informally, any US rate cut has immediate implications for them. These Asian, East European and Latin American countries are forced to follow suit, lest their currencies appreciate as investors seek higher yields and their exports become uncompetitive. The loose US monetary policy, it is argued, may therefore have set the tempo for "inflation in a significant chunk – perhaps as much as 60% – of the global economy".

About the possibilities facing the world economy, Ken Rogoff writes, "If the US tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing. Global commodity prices will collapse, and prices for many goods and services will stop rising so quickly as unemployment and excess capacity grow." On the other hand, "a US recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the US recession remains mild and global growth remains solid. In that case, inflation could easily rise to 1980’s (if not quite 1970’s) levels throughout much of the world."

Though Prof Rogoff may be partially correct, there are important differences across the US and rest of the world. The problems and hence choice facing the developing countries, including the dollar bloc of developing economies, are different from that facing US. The inflation in the US, despite showing signs of a slow rise, is at a relatively low 4% and may not be an immediate danger. But the credit crisis which threatens to drag down the real economy means that a loose monetary policy is imperative. In contrast, the emerging economies are in strong shape but are facing sharply climbing inflation in the face of rapidly rising energy and commodity prices.

The European Central Bank (ECB) has hitherto adopted a wait and watch policy, concerned at the rising Euro which is eroding their export competitiveness, but also happy that the cheaper imports have kept a lid on domestic inflation. Any medium term hike in rates is virtually ruled out, except in extraordinary circumstances, as it would drive the Euro up even higher. Interest rates are at a low 0.5% in Japan, and inflation at 0.8% is even too low for comfort.

Ken Rogoff assessment may also have over emphasized the importance of the US economy and under estimated the increasing share of the emerging economies in global economic growth. It is estimated that the US contributed less than 20% to the global economic growth in 2007, whereas India and China combined contributed more than 40%. The robust domestic demand in many of these countries, especially in non-tradeable services like infrastructure, may be enough to offset any fall in demand arising from a US slowdown. Despite all the recent US recession talks and falling consumption demand there, oil prices have continued to rise.

Robert Reich argues that for far too long now the US consumers had kept the party going on everywhere. But unlike old times, when a US recession dragged the world economy with it, the massive stock of petro dollars that record oil prices have built up in the Middle East and sino dollars that the Chinese economic boom has accumulated, is most likely to now ensure that a large part of the world economy stays afloat. Add to this the robust domestic demand in many emerging economies like India and buoyant commodity export incomes in Latin America and East Asia, and we have the recipe for a decoupling. As Robert Reich says, the middle classes in these countries have joined the consumption party, which has just started and is set to go on for some time.

He writes, "Consumer spending is rising almost three times as fast in developing nations as in rich nations. Real capital spending is rising by double digits there while it's rising only a bit over 1 percent a year in rich nations. And emerging economies' trade with each other is increasing faster than their trade with richer nations."

He also argues that the decoupling will have both good and bad news for US. The good news will be that the insatiable emerging market demand will boost US exports, generate handsome returns for US corporates, and provide enough capital to a credit straved Wall Street and US financial market. But the bad news is that unlike in the past when US recessions depressed global demand and kept prices low, the emerging market demand will keep commodity prices high. This will make the US recession even worse. Which of these two trends will predominate and for how long, will be difficult to predict.

What puts the US at a disadvantage relative to the others is the poor health of its financial sector and the virtually negative household savings. The last two decades of asset inflation based "income effect" has made a generation of Americans abandon savings, and thereby made household consumption dependent on the vagaries of the financial market. The US financial market is in a very bad mess, brought about by its own doing. In contrast, the fundamentals of the real economy remains strong, thanks to the efficiency improvements and massive cuts in workforce of the late nineties and early years of this decade.

The spectacular securitization led financial innovation of the last two decades, assisted by the historically low interest rate regime and asset bubbles in first stock and then housing markets, have driven down household savings and tightly knit up the fortunes of even households to that of the financial markets. Unlike the Europe and elsewhere, the private sector has long relied on financial markets to raise its funds. But now, with counter-party risk at its highest and banks unwilling to lend to even each other, the market for even plain vanilla debt instruments like commercial paper has dried up. This has forced the deferment of corporate investment plans. In many respects, the problems faced by Main Street are made in Wall Street - credit squeeze, widening interest rate spreads, flat demand for commercial paper, weak consumption demand as the wealth effect from the housing and stock market bubbles declines etc. So it is understandable that if Wall Street sneezes, credit dries up and Main Street catches cold.

The present crisis starkly highlights the rapidly emerging divide between the financial markets and the real economy. While Wall Street, and to an extent global financial markets, would prefer ever lower interest rates to combat the credit squeeze, the Main Streets across the world appear more concerned about inflation and its potential impact on economic growth. Wall Street would prefer a few years of high inflation rather than suffer a credit squeeze inspired short recession.

Nouriel Roubini captures the US recession balance sheet here. Then there are those like Paul Krugman, who feel that some inflation is actually desirable, in that it gives the Fed the freedom to keep real rates negative for some time. This is necessary in a weak environment like now, so as to give all the opportunity to stoke a recovery. He contrasts the present crisis in the US with the liquidity trap which Japan got into in the nineties due to the absence of this inflation buffer.

As Martin Wolf argues, the core inflation, stripped off volatile food and energy prices, has been on the upward trend in the US since 2003 and in EU since 2006. He claims that we are seeing a "global shift in relative prices, with commodities, particularly energy, becoming much more expensive, relative to manufactures". About the reasons for this trend, he writes, "The emerging economies and, overwhelmingly, of China, has accounted for the bulk of global incremental demand for industrial raw materials. Mandates to produce biofuels have also had an impact on demand for some agricultural commodities. Also important have been constraints on supply: bad harvests, inadequate investment and higher costs. The rising price of energy is itself a big reason why agricultural production has become far more expensive."

Martin Wolf feels that a big rise in relative prices of commodities will raise measured inflation and shrink the output of commodity-using sectors, aggregate real incomes and real demand. He advocates a three-fold action path for Central Banks
1. Remind the public that monetary policy cannot give them back the real incomes that higher commodity prices have taken away
2. Ignore what seem temporary fluctuations in relative prices, since a response would generate unnecessary economic instability
3. Respond to prolonged and continuing rises in relative prices. If they do not do so, upward shifts in inflation expectations and the inflation-risk premium in interest rates are likely.

In the US today, inflation expectations are on a knife edge. Since the January federal open market committee meeting, longer-term rates, including those on fixed mortgages, have risen rather than followed the federal fund rates downward. In such circumstances, a policy of aggressively cutting short term rates, may end up introducing significant long term distortions in the basic character of the financial markets and the economy itself. Apart from the domestic consequences, through its aggressive monetary loosening, the US is also maintaining the downward pressure on dollar and thereby end up exporting inflation to the emerging economies. The assumption that Fed can cut rates without fear of the consequences is plain wrong.

The final word should go to Martin Wolf, who argues that the right policy lies between the Fed’s one of doing everything possible to eliminate downside risks and the European Central Bank’s one of masterly inactivity. The Fed should be aiming at ensuring as soft a landing as possible, but a landing nevertheless. But for the developing countries, the choice may be to retain interest rates at the same level as far as possible, till inflationary expectations and trends makes tightening inevitable.

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