Thursday, 3 October 2013

Inflation – Then and Now

Inflation is driven by different factors now that the West is no longer the only engine of growth in the global economy but why might that be important?

Life is always better as the top dog, whether it be on the playground or at work. The same holds true for the global economy where large and growing countries have others banging on their door to offer whatever they might need.  As a result, the global economy shapes itself around the countries at the top of the pecking order and these countries benefit as a result.  One seemingly innocuous way this plays out is through inflation.  Inflation in Europe and the United States has always moved in tune with their economies due to there being no other significant sources of demand.  But the switch to a global economy with other major players has resulted in international commodity prices being driven by what is going on in other countries as well.  This means that inflation is not what it used to be.  And, if inflation is different, must monetary policy change as well?

Inflation is the economic phenomenon of increases in prices, where prices will rise if demand increases at a faster rate than supply.  Due to globalization, many goods are now traded on international markets and growth in the global economy will push up demand (and the price) for any goods.  While demand can fluctuate dramatically in a short period of time, changes in supply typically take time.  Prices which rise due to expanding demand as an economy grows may remain high as increases in production require more time to catch up.  This is not so much of a problem when an economy is growing as consumers will have more money in their pockets and won’t be as bothered by higher prices.  Thus, it is easier to accommodate prices rising at a faster rate when the economy is prospering. 

In the past, the main source of demand for most products came from Western economies (Europe and the United States) along with Japan, with inflation moving in line with economic growth in these countries.  The level of synchronisation between these economies was also high so that growth spurts came at the same time and inflation was typically timed to when the economy was ready for it.  But this all depended on there being no other big economies which were out of sync with the West.

However, the economic rise of China and emerging markets put paid to this convenient form of inflation.  The number of factors which determined global commodity prices had increased and the economy in China was large enough to move to its own rhythms.  China’s entry into the global economy was initially a boost for Europe and the United States in some ways with low-cost manufacturing helping to bring down prices at the beginning of the century.  Yet, economic growth in China did not slow with the onset of the global financial crisis and prices for many global commodities kept climbing higher as a result.

High inflation is never good but it is even worse when an economy is struggling to climb out of recession.  Rising prices during slow economic growth further depress spending and put pressure on profits at companies when times are already tough.  Being an open economy with few of its own resources, the United Kingdom has had to suffer through both a stagnating economy and high inflation.  For example, real GDP in the UK edged up just 0.8% in 2011 while inflation reached as high as 5.2% in September.  Yet, the Bank of England did not change its monetary policy to quell inflation in 2011 as it was clear that the origin of the inflation was overseas. 

However, the situation may not always be so clear cut.  And it is not the first time that inflation has been out of whack with what is going on in the economy.  Interest rates were kept down in the lead up to the global financial crisis as inflation was weak due to cheap goods coming in from China.  The lower borrowing costs spurred on the lending binge which accentuated the crisis.  Inflation was picked out as a gauge which reflects the strength of an economy but it is questionable whether that is still the case. 

Europe and the United States are already struggling to deal with the rise of new challengers (for more on this, refer to A New Inconvenient Truth) as well as the aftermath of the global financial crisis (see economy still stuck in a rut for more).  Shaping monetary policy around something which is influenced by external factors is not going to be helpful in steering clear of trouble.  And, inflation in itself is not enough of a negative for the economy to be managed for its own sake (go to time to rethink inflation?).  Monetary policy should instead look at other measures of economic health such as unemployment which is obviously something that needs to be lower (to a certain degree). 

A more relevant basis for monetary policy would help bring much-needed clarity with regard to the direction of monetary policy as we wait for the Federal Reserve to start the long process of ending its quantitative easing policy.  Central banks have a lot to answer for in terms of their role in the lead up to the global financial crisis and improving the way in which the economy is managed would go a long way toward making amends.

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