In search of inflation!

Six months back Central Banks across the world were busy fighting rising commodity, energy and foodgrain prices, as the world appeared perched on a spectacular inflationary bubble. Three months back it was being debated that the rapidly growing inflation spiral would determine the result of the general elections in India early next year. Policy makers and Central bankers were debating whether aggressive inflation targetting was needed to contain the surging inflation, even at the cost of economic growth.

Fast forward to today. The latest inflation figures show that the annual Wholesale Price Index (WPI) rose 6.38% during the week ended December 20, down from the previous week's rise of 6.61%, and far cry from the 16 year high of 12.92% in August 2008. As tables get turned, deflation (not so much in India, atleast for now) and economic growth has replaced inflation as the focus of attention.

In one of the most spectacular about turns in the history of monetary policy making, inflation targetting has been replaced by monetary loosening and liquidity injections (to the extent of "helicopter drops"!) as the primary concern of Central Banks across the world. A deflation coupled with economic recession (or stag-deflation) is a nightmare for policymakers. Therefore, in the space of a few months, from fighting the beast of inflation, Central Bankers are left searching out ways to stoke inflation so as to contain the deflationary spiral.

Paul Krugman writes that the time has come for Central Banks to "credibly promise to be irresponsible". He had strongly advocated stoking inflation as a necessary antidote for Japan's deflation induced liquidity trap of the nineties. He writes, "Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem."

Greg Mankiw also recently suggested that with rate cuts and monetary policy becoming effectively irrelavant, the Fed should switch over to a policy of maanging inflationary expectations by committing to a modest amount of inflation. Olivier Jeanne and Lars E O Svensson, in an NBER working paper, argue that "an independent central bank can manage its balance sheet and its capital so as to commit itself to a depreciation of its currency and an exchange-rate peg, whereby, it can implement the optimal escape from a liquidity trap, which involves a commitment to higher future inflation".