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Monday, July 28, 2008

"America Must Not Act Rashly over Inflation"

I agree with this - the Fed should not be in a hurry to raise interest rates due to concerns about inflation. This inflation, unlike some in the past, is being driven by increases in the price of oil, food, and other commodities, it's not primarily the result of excessive increases in liquidity (money growth).

Inflation that is driven by excessive money growth needs to be controlled, and the solution is for the central bank to reduce the growth in liquidity by increasing interest rates. But inflation that is driven by changes in relative prices is different. These price changes are providing important signals to the economy about where resources are needed most and about the opportunity cost of employing them, and we don't want to mute those signals (though it is sometimes useful to attenuate the signals and smooth the adjustment). Eventually, the relative prices of these goods will increase enough to bring global growth in demand and global growth in supply back into balance, at which point prices will stabilize and so will inflation. The increase in relative prices is necessary to bring the underlying fundamentals driving supply and demand growth back into balance. As Mark Gertler says below, "the relative increase in energy and food prices is something beyond the central bank’s control...," but once the relative price increases have occurred, inflation should subside on its own. The biggest danger to the economy is further credit market troubles, not inflation, and increasing interest rates in an attempt to stave off inflation would increase the risk lower output growth, lower employment, and prolonged stagnation in the economy:

America must not act rashly over inflation , by Mark Gertler, Commentary, Financial Times: The startling jump in US consumer price inflation ... has sparked concern over whether the economy is entering an inflationary spiral similar to that of the 1970s.

Lost in most of the commentary about inflation has been a careful inspection of its underlying mechanics. Almost all the recent increase in headline consumer price index inflation is due to rocketing energy and food prices. Inflation excluding energy and food is significantly lower.

The increase in the core CPI over the past year was just 2.4 per cent, slightly above the Federal Reserve’s comfort zone of 1 to 2 per cent. The feeding through of food and energy costs to core prices did produce an uptick this past month. Over the coming year, however, below-capacity output growth and softening oil and commodity prices are likely to push core inflation back towards the comfort zone.

Why care about headline inflation versus core inflation? Simply put, a sustained move of headline inflation to the levels of the 1970s is unlikely without an accompanying increase in the core component. The reason is simple: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it. ...

Indeed, there are signs that the forces that have pushed headline above core inflation are beginning to reverse course. ...

Could it be that high headline inflation is unmooring inflation expectations, leading us back to the 1970s through this painful route? Some measures of inflation expectations are edging upwards. This needs to be taken seriously. However, where we should expect the impact of increasing expectations to show up is exactly in the behaviour of core prices and wages.

So far this is not happening. Not only has core inflation remained stable but the growth in nominal unit labour costs, on which most pricing of core items is based, also remains benign. It may very well be that the Fed’s reputation for keeping core inflation stable has kept the expectations relevant for price- and wage-setting in line. Also relevant is that ... wage- setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank’s control that they must live with. ...

Keeping inflation under control is a real concern and I do not mean to suggest otherwise.

What is required, however, is a policy response that recognises the complexities of the inflationary process, including its global nature, and not a simple knee-jerk reaction. From Japan in the 1990s we know that a fractured credit system can induce prolonged stagnation, even in an advanced economy. Given the uncertain condition of the US financial and real sectors, the goal should be to achieve price stability in a way that continues to keep low the possibility that this economy could suffer a similar fate.

    Posted by on Monday, July 28, 2008 at 02:07 PM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (1)  Comments (36)

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