Is inflation the right battle?

Wednesday 19th November 2008

J. Bradford DeLong

You need to pick your battles, and with the global economy instigating fights on all fronts, governments need to be sure they're committing to the right ones

The Federal Reserve and other central banks are coming under pressure from two directions these days: from the left, they are pressured to do something to expand demand and hold down global unemployment; from the right, they are pressured to contract demand to rein in inflation.

This is a situation ripe for trouble, because one of these two diagnoses must be wrong. If the world’s central banks raise interest rates while the major problem is insufficient global demand, they might cause a depression. If they do not raise interest rates while the major problem is inflation, they might cause spikes in prices, rising inflationary expectations, and a stubborn wage-price spiral like that of the 1970’s that can be unwound only with a later, deeper depression.

I see the left as being correct – this time – in the global economy’s post-industrial North Atlantic core. Headline inflation numbers are the only indication that rising inflation is a problem, or even a reality. The American Employment Cost index and other indicators of developed-country nominal wage growth show no acceleration of change. And “core inflation” measures show no sign of accelerating inflation either.

The United States is experiencing a mortgage loss-driven financial meltdown that would, with an ordinary monetary policy, send it into a severe recession or a depression. In normal times, the Fed’s response – extremely monetary stimulus – would be highly inflationary. But these are not normal times. Indeed, the Fed’s monetary policy has not been sufficient to stave off a US recession, albeit one that remains so mild that many doubt whether it qualifies as the real animal.

The European Central Bank’s response has been analogous to the Fed’s, but less forceful, with monetary policy easier than the headline inflation rate would suggest is appropriate. And in Western Europe, too, GDP is now declining.

In brief, the major central banks on both sides of the Atlantic have responded to the financial crisis, but they have not overreacted. Even with their liquidity injections, the fallout from the financial crisis has eliminated the risk of a wage-price spiral that might otherwise have arisen.

Yet headline inflation is soaring, and, not surprisingly, gets the headlines. This reflects three developments. First, the world has, for the moment at least, reached its resource limits, and we are seeing a big shift in relative prices as the global economy responds appropriately by making labor and capital cheap and oil and other resources expensive. The result of this relative price shift is headline inflation.

Second, inside the US, the return of the dollar toward its equilibrium value is carrying with it import price inflation. Costs to US consumers are rising and making them feel poorer, not because they have become poorer, but because the previous pattern of global imbalances exaggerated their wealth. Global rebalancing is painful for American consumers, and shows itself as higher headline inflation. But to respond by fighting inflation inside the US would be grossly inappropriate – both much more painful for US consumers and pointless.

Finally, as the economists Adam Posen and Arvind Subramanian have argued, “China’s single-minded pursuit of mercantilist objectives produces inflation and overheating at home.” But “US efforts to get China to shed these objectives sound hypocritical when the United States seems to be opting for excess stimulus itself....[I]f the People’s Bank and the Fed tightened in coordination with most central banks, domestic [Chinese] concerns about competitive depreciation would be muted...”

China’s policy of export subsidies through currency manipulation was always bound to become unsustainable in the long run because it was bound to generate substantial domestic inflation. Now it is also generating substantial pain for other developing countries as China’s booming economy outbids them for resources. But it is politically impossible for the Chinese government to alter its exchange-rate policy under pressure without some “concession” from the US, and a tightening of US monetary policy could be sold as such a “concession.”

But this overlooks what ought to be at the center of the discussion: higher US unemployment right now is not an appropriate goal for stabilizing US output and offers few benefits, if any, for stabilizing US prices. Nor is a US that cuts back on import purchases more rapidly in the interest of any export-oriented developing economy – including China.

Copyright: Project Syndicate, 2008

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