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Thu Oct 20 12:13:37 PDT 2005

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THE SCOURGE RETURNS
Oct 20th 2005  

Central banks cannot ignore the latest spurt in inflation

KARL OTTO POHL, a former president of the German Bundesbank, once
remarked that "inflation is like toothpaste. Once it is out of the
tube, it is hard to get it back in again." Apparently not that hard.
Until recently it looked as if inflation had been defeated in most rich
countries. But it has risen sharply this year in America, the euro area
and Britain. America's inflation rate has almost doubled over the past
year to 4.7% in September, its highest since 1991. Embarrassingly,
inflation is now higher than when Alan Greenspan, the soon-to-retire
chairman of the Federal Reserve, took office in 1987. 

 British inflation is equally embarrassing for the Bank of England. It
has risen from 1.1% to 2.5% over the past year, well above the Bank's
2% target and the highest rate since 1996. The average inflation rate
in the G7 countries now stands at an estimated 3.2%, its highest for 13
years. Excluding Japan, where consumer prices continue to fall slowly,
the average inflation rate is 3.7%. This is hardly hyperinflation, but
it is also not most people's idea of price stability.

 The Fed, the European Central Bank and the Bank of England are
suddenly sounding more hawkish. It is true that the leap in inflation
is largely due to higher oil prices, and the core rate (which excludes
oil) remains tame in most countries. But central bankers are worried
that higher oil prices could feed into other prices and wage demands.
According to a closely watched survey by the University of Michigan,
American consumers' expectation of inflation 12 months ahead jumped to
4.6% in early October from 3.1% in August. 

How should the guardians of the world's money respond? The conventional
wisdom is that central banks should focus on core inflation, since oil
prices are affected by temporary supply shocks. But the rise in crude
oil prices over the past few years has largely reflected strong global
demand rather than a disruption to oil supply, and the futures markets
think that most of the rise is permanent. If so, it will eventually
affect core inflation. Moreover, the headline inflation rate, including
oil, matters because it is the one that consumers experience, and so
can influence inflation expectations and wage claims. 

A central bank cannot prevent oil prices giving a one-off boost to
inflation, but it can try to prevent this feeding into higher wages and
prices. To ensure that the rise in inflation is only temporary, central
banks need to increase interest rates at least in line with inflation.
If central banks hold interest rates unchanged as inflation rises, this
would imply lower real rates and hence an easing of monetary policy.
Global monetary policy is still unusually lax by historical standards.
In America, despite 11 increases in interest rates since June 2004,
real rates are still negative and below any reasonable notion of the
"neutral rate of interest" at which monetary policy is neither
stimulating nor restraining the economy. In other words, the Fed will
need to keep pushing up interest rates into 2006. 

In the euro area, real interest rates are also negative and at their
lowest in history. So it is hardly surprising that the ECB has started
to hint that it may need to raise interest rates. In Britain, where
spending has slowed sharply over the past year, rising inflation is
more likely to delay rate cuts than to trigger an increase. Mervyn
King, the governor of the Bank of England, gave warning last week that
monetary policy must focus on inflation and can do little to counter
the slowdown. 

A REVERSAL OF FORTUNES
On top of the impact of higher oil prices on inflation, there is
another reason for central banks to remain on guard. Over the past
decade, central banks have had a big helping hand in holding down
inflation from faster productivity growth in some countries (thanks to
information technology), and from the integration of China into the
world economy. By increasing the world economy's growth potential,
these factors allowed America in particular to grow faster without
inflation. At some point, the impact of IT and China on inflation could
fade or even go into reverse (see article[1]). If this happened at the
same time as a surge in oil prices, inflation could take off more
quickly than it has for many years. 

That is not a reason for central banks to push interest rates up
sharply today. But if house prices and consumer spending stumble,
neither should central bankers slash interest rates as it is now widely
expected that they would do. As long as inflation remains well above
central banks' desired targets, they would be wrong to cut rates. That
would be to turn a blind eye to history. The bitter experience of the
1970s shows that the first signs of rising inflation should never be
ignored. 

-----
[1] http://www.economist.com/displayStory.cfm?story_ID=5054125

See this article with graphics and related items at http://www.economist.com/displaystory.cfm?story_id=5056320&fsrc=nwl

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