A Wobbly Coalition Of The Unwilling

The world economy may be heading for a rerun of the 1970s “Great Inflation,” this time maybe more severe as it is coinciding with a credit crunch and asset deflation in several advanced economies.

Though high oil and commodity prices, housing busts, declining wealth and tighter credit have already crimped the developed-world demand. Meanwhile, the developing-country boom over the past few years has now been followed by the negative supply shocks from rising oil and commodity prices, poor weather, trade barriers and tighter environmental regulations, all of which have helped contribute to inflation.

The forces behind the Great Moderation (stable growth and low inflation), such as better inventory management, inflation-targeting, globalization and financial innovation, are losing their power to lower and stabilize inflation. Import prices are rising thanks to higher production and transportation costs, tighter inventories keep commodity prices high and volatile, and monetary policymakers have their hands tied as downside risk to growth (that require lower policy rates) are constrained by rising inflation (that requires higher policy rates).

As in the early 1970s, loose monetary policy in the U.S. together with the dollar-fixed or heavily managed exchange-rate policies of many emerging economies has led to excessive growth and liquidity in these countries, further feeding the commodities boom, and inflation. Emerging markets that explicitly or implicitly peg their currencies to the dollar severely undercut their ability to fight inflation through currency appreciation.

The U.S. has not yet resorted to Nixonian price and wage controls, but price controls and subsidies in developing countries allow at least half the world population to pay less than the world price for fuel and food, distorting the market and undermining the demand destruction that would ultimately help bring prices down. Now, some producers are beginning to pass on price increases to consumers: a string of steel producers recently announced steel price hikes due to the doubling cost of their inputs, coal and iron ore. Those increases will eventually trickle down, raising prices on consumer goods like cars and appliances.

Unlike in the 1970s, no wage-price spiral has taken hold yet on a widespread basis, with exceptions in some emerging markets and parts of Europe. Without this key ingredient of wage inflation, many economists believe high inflation is a temporary phenomenon. The lack of wage inflation is a double-edge sword however, as stagnant wages amid rising prices for goods and services cut consumer purchasing power. This, in turn, can push up inflation expectations if consumers believe their income will buy increasingly less in the future. Second-round effects have begun to appear in parts of Europe and the developing world. Generally, inflation is still lower than it was in the 1970s and core inflation trends remain moderate. Comparisons with the 1970s aside though, several factors point to persistently higher inflation despite a global demand slowdown. Most of the world’s population already suffers from double-digit consumer inflation. Consumer inflation in developed countries remains in the single digits, but is high after a long period of disinflation in the 1980s and 1990s.

Unfortunately, there is little that individual rate hikes in the developed world could do to stem the rise of commodity prices in the face of strong emerging-market demand. Emerging markets should raise policy rates more significantly before a sharp upward shift in inflation expectations triggers a wage-price spiral. But more likely these economies—where the commodity price shock is breeding social turmoil—will be unwilling to tighten monetary policy enough and let their currency appreciate enough to control inflation. The slowdown in domestic growth that such deflationary policies would imply would compound the growth slowdown due to the G7 economic slump. The result may be a policy mistake that will lead to a rise in global inflation.

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