Wednesday 27 August 2008

Inflation expectations lead to more inflation, right?

Generally it is argued that rising inflation expectations will lead eventually to higher inflation. Hence, it is no surprise central banks are monitoring such expectations closely and typically will raise interest rates if such events occur. Globally, inflation expectations have shot up - primarily driven by rising energy and food prices.
Thus, should central banks repeat the standard response by tightening their monetary policies? Larry Hatheway, chief economist at UBS, does not think such a policy would necessarily be such a good idea:
"Ever since Milton Friedman's address to the American Economic Association in 1968 and the ensuing theoretical work by Robert Lucas and others in the 1970s, the mantra - at least among central bankers - has been that rising long-term inflation expectations inexorably lead to higher inflation.
The central question is not about inflation expectations, per se. Nor is it about commodity prices, however quickly they may be rising. Rather, inflation is determined by the interplay between monetary conditions and capacity in the economy to grow without pushing most prices higher. That is where the story gets more complicated. Are monetary conditions easy? Is there spare capacity?
In the US, slack is appearing in the economy, as seen in rising unemployment, now up to 5.7 per cent. Negative real interest rates suggest monetary conditions are easy. But the Fed's own surveys suggest that bankers are less willing to lend; consumers less willing to borrow. Low real interest rates are a manifestation of economic and financial malaise, not excessive monetary accommodation. Altogether, the case for accelerating US inflation looks weak in the face of below-trend growth and stuttering credit conditions.

In the UK, consumer borrowing is falling sharply, the housing market is following its US counterpart into deflation, and consumers are retrenching. Here too, underlying inflation pressures ought to moderate.

In the eurozone, the picture is less clear. Money and credit growth have remained in double-digit territory and economic activity has been robust in recent years. Some signs of higher wage settlements are evident. But the most recent data also point to a sharp slowdown in the eurozone economy.

So, what are we to make of higher inflation expectations in the US and western Europe? Investors and households seem to believe energy and food prices will continue to rise. But will other prices and wages automatically follow suit? Stagnating growth and tighter credit conditions suggest the opposite.

Perhaps that is why consumer confidence has plummeted on both sides of the Atlantic. Eating and driving are more expensive, but weak growth, rising unemployment, and fear of outsourcing are keeping most wages in check.

In short, households may say they expect higher inflation, but there is little they can do about it. The reality is they are experiencing falling real incomes and pinched balance sheets. That is hardly the stuff of overheating.
The Friedman-Lucas emphasis on inflation expectations was a model suited to different times. Central bankers no longer try to ramp growth by springing inflation surprises on unwitting workers. Unionisation has declined, automatic cost-of-living adjustments are rare, globalisation has reduced pricing power for most companies and bargaining power for most workers.
Today, advanced economies are confronted with stagnating growth, collapsing housing markets, slowing world trade, stressed financial systems, and weak household balance sheets. This is not the 1970s. Broad-based price and wage inflation is unlikely today. We should therefore be sceptical of the case for tighter monetary policies based on models developed in, and better suited for, a bygone era."
Quoted from: Hatheway, L., 2008. "An Inflation model from a bygone era" Published: FT.com, August 24

No comments: