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Monday, March 10, 2008

Who's Afraid of the Big Bad Inflation Wolf?

Ken Rogoff says central banks don't seem to be afraid of inflation, but they should be:

Inflation Reality Check, by Kenneth Rogoff, Project Syndicate: As inflation continues to soar everywhere, maybe the world's central bankers need a jolt to awaken them from complacency. How about holding one of their bi-monthly meetings in hyperinflationary Zimbabwe? It might not be comfortable, but it would be educational. ... Zimbabwe does have a good shot at breaking world records for inflation. ...

Many central bankers and economists argue that today's rising global inflation is just a temporary aberration, driven by soaring prices for food, fuel, and other commodities. ... But if central bankers think that today's inflation is simply the product of short-term resource scarcities as opposed to lax monetary policy, they are mistaken.

The fact is that around most of the world, inflation ― and eventually inflation expectations ― will keep climbing unless central banks start tightening their monetary policies.

The U.S. is now ground zero for global inflation. Faced with a vicious combination of collapsing housing prices and imploding credit markets, the Fed has been aggressively cutting interest rates to try to stave off a recession. But even if the Fed does not admit it in its forecasts, the price of this ''insurance policy" will almost certainly be higher inflation down the road...

[M]any countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements. As a result, whenever the Fed cuts interest rates, it puts pressure on the whole ''dollar bloc" to follow suit, lest their currencies appreciate...

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ― perhaps as much as 60 percent ― of the global economy.

But, with most economies in the Middle East and Asia in much stronger shape than the U.S. and inflation already climbing sharply..., aggressive monetary stimulus is the last thing they need right now. ...

So what happens next? If the U.S. 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.

Of course, a U.S. recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the U.S. 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.

Until now, most investors have thought that they would rather risk high inflation for a couple of years than accept even a short and shallow recession.

But they too easily forget the costs of high inflation, and how difficult it is to squeeze it out of the system. ...

Robert Reich says not to count on commodity prices falling to ease inflationary pressures:

The American Recession and the World's Emerging Economies, by Robert Reich: It used to be that when the American economy sank into recession, developing economies sank along with it. But that probably won't happen this time. And a big reason lies in the Middle East and in China.

Much of the Middle East is swimming in oil money -- petro-dollars -- while China has built up its own huge stock of sino-dollars. These petro-dollars and sino-dollars aren't just sitting there in the Middle East and in China. They're being put to work - building new infrastructure in both places: skyscrapers, power plants, power grids, roads, ports. And building middle classes...

All this spending on infrastructure and on goods and services by emerging middle classes, in turn, is pulling in resources, goods and services from the rest of the world. That includes exports from other emerging economies.

This means the world's developing nations are no longer nearly as dependent as they used to be on consumers in the United States and other rich nations to keep them going by buying their exports. ...

Is this de-coupling of emerging from developed economies good news for the United States? Yes and no. It's good news to the extent that even as America falls into recession, developing nations will continue to demand some of our exports. They'll also continue to generate healthy returns for American investors... And they'll invest in U.S businesses and financial institutions that desperately need the capital. ...

But in a more significant way, the de-coupling is not at all good news for us. It means the price of many things we buy from developing nations -- especially raw materials like oil - will continue to be high, and might even rise. ...

So it's two cheers for the developing world. Emerging economies are growing almost regardless of downturns in rich nations. In terms of global equity and long-term stability, we should all be happy about that. But viewed narrowly and in the short term, from the perspective of world's richest nation now heading into deep recession, it's only two cheers rather than three.

From a risk management perspective, which is worse? To be stuck with persistent inflation that will require rates to be higher than they would otherwise when times are better, or to plunge into a downward spiral where the real economy, i.e. things like real GDP and employment, plummet. I continue to believe that output and employment plunging into a deep recession is the greater risk, and trying to fight inflation now only makes that risk worse. We shouldn't ignore inflation, but that should not be our primary concern right now.

    Posted by on Monday, March 10, 2008 at 01:19 PM in Economics, Inflation, Monetary Policy, Unemployment | Permalink  TrackBack (0)  Comments (38)

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