Inflation here, there and everywhere

What is inflation?

Inflation is rising just about everywhere. Why is this and what can be done about it?

To get some basic concepts clear: inflation is a sustained rise in the general price level. Both the words ‘sustained’ and ‘general price level’ are imprecise and in need of operationalisation. By general price level I mean a broad, representative index of consumer prices. That excludes the (headline) CPI in the UK because, like the other EU harmonised price indices, it excludes housing costs (that is, the rental cost of housing services or the imputed rental paid by owner occupiers). This makes the CPI/HICP indices unrepresentative, unless either the relative price of housing services and the goods and services included in the CPI/HICP remains constant or UK/EU citizens live in cardboard boxes provided free of charge by the Salvation Army. It may come to that, but not yet. The UK’s RPI and RPIX indices would be more representative.

I also exclude as unrepresentative various ‘core’ price indices, which exclude from the headline index such things as food, drink, energy and fuel. Among leading central banks, only the Fed has focused mainly on core inflation rather than on the headline index of consumer goods and services prices. Focusing on core inflation will be misleading unless either the relative price of core and non-core goods and services is expected to remain constant or Americans don’t eat , drink, drive cars and heat their houses or use air conditioning.

Until recently the Fed believed (a) that the best forecast of the future relative price of core and non-core goods and services was the current relative price of these sub-indices and (b) that the prices of non-core goods (mainly energy, fuel and agricultural commodities-based products) were more volatile than those of core goods and services. The volatility point was and remains empirically correct. The random walk or martingale hypothesis for the relative price of core and non-core goods was always a bad assumption empirically. In the most recent phase of globalisation, which has for much of this decade delivered a steady increase in the relative price of non-core goods to core goods and services, the assumption that it is OK to take this relative price as constant in the future is bad statistics and bad economics. Fortunately, the Fed is showing signs of kicking its core inflation habit, although painful withdrawal symptoms still are apparent from time to time. Admitting you have geen wrong is almost as difficult for central bankers as it is for politicians.

By ‘sustained’ I mean,…uh, well, you know, something like ‘persistent’. And by ‘persistent’ I mean ‘sustained’. Unsustained would be any one-off increase in the level of the price index that is not associated with expectations of further increases. I know this is vague and unsatisfactory, but welcome to the world of applied social science. For practical purposes, a representative price index that rises for more than two years would indicate inflation.

Who or what causes inflation?

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always be offset by the central bank, given enough time, freedom to act and courage.

But, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices – in the real prices of oil, of food, of oil and of labour for instance – if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

Sometimes the central bank is the political captive of the fiscal authority. This is most clearly the case in countries with underdeveloped financial systems where seigniorage (the revenues appropriated by the central bank through the issuance of fiat money) is a significant source of government revenue and the central bank is not operationally independent. Sometimes the revenue needs of the government force a non-independent central bank to monetise the governments deficits. Zimbabwe is an example today. This is not a relevant consideration in today’s advanced industrial countries, as the revenue from seigniorage is tiny (around 0.25%-0.5% of GDP or less).

But with an operationally independent, sufficiently well capitalised central bank, the monetary authorities can, on average in the medium and long term, achieve the inflation rate they want. They are responsible, no-one else.

I assume, of course, that the exchange rate either floats or is set by the central bank. With a fixed exchange rate, or an exchange rate whose value is not set by the central bank, there is no substantive central bank independence. Given a floating exchange rate or a central-bank-set exchange rate, the central bank can make inflation in the medium and long term anything it wants it to be.

The central bank pursues its inflation objective by raising its policy rate (a short default-risk-free nominal interest rate) whenever inflation is expected to be above target over the horizon the central bank can influence it in a predictable way (starting between 6 and 12 months from the present), and by lowering the policy rate whenever inflation is expected to be below target. It’s simple, really. In financially repressed systems like India, the interest rate instrument (a) cannot be used freely because of political constraints and (b) has only a very small anvil to hit. So credit controls, including selective credit controls have so supplement the exchange rate as anti-inflationary instruments. It is clear that the Chinese authorities either don’t know the degree of monetary tightening (through credit controls, interest rate increases and yuan appreciation) that is required to bring inflation first under control and then down to a lower level, or that the economically necessary degree of monetary, credit and exchange rate tightening is noty yet politacally feasible.

Inflation is rising (almost) everywhere

The UK just got a nasty inflation shock. On the Bank of Englan’s official target, the CPI, year-on-year inflation in April came out at 3.0 percent, a full percent above the 2.0 percent target. Any higher and we would have had another Letter of St. Mervyn to the Tresorians. We are likely be see another couple of espistels again this year. The increase from 2.5 to3.0 percent was both large and larger than expected. It was preceded by a slew of data showing manufacturers costs and prices rising at alarming rates. The imminent interest rate cuts that had been anticipated by markets because the marked economic slowdown that is under way will reduce capacity utilisation and bring inflation down, are likely to be shelved for the time being. If the coming months confirm the pattern of higher than expected inflation, interest rate hikes must be on the cards for the UK, as even quite sharp increases in excess capacity may not be enough to bring inflation back to its target sufficiently quickly.

The reporting of the increase in UK inflation has been abominable, even in papers that still credit their readers with IQs in double digits. The Financial Times contained a deeply misleading article headed “Familiar culprits drive surprise jump in bills”, with above it “7.2% food, 8.3% household energy,…., 18.7% fuel for transport…” etc. This is major-league disinformation as regards the drivers of inflation. There is indeed a familiar culprit for the increase in the cost of living – the Bank of England’s Monetary Policy Committee. The fact that this rise in inflation is accompanied by shocks that cause major changes in relative prices, including a nasty adverse terms of trade shock for the British consumer, is neither here nor there as regards the overall rate of inflation. If fuel for transport, food and household energy had not gone up at all, other prices would have gone up by more to produce pretty much the same overall rate of inflation.

I am willing to grant the old-Keynesians and new-Keynesians among us, the empirical regularity that at very high frequencies, the fact that most nominal commodity prices (and prices of non-core goods in general) are flexible (both ways), while most nominal core goods and services are sticky in the short run. So relative demand or supply shocks that cause the relative price of non-core goods to go up will tend to do so in the first instance through an increase in the nominal price of non-core goods rather than through a reduction in the nominal price of core goods and services; likewise relative demand or supply shocks that cause the relative price of non-core goods to do down will tend to do so in the first instance through a decline in the nominal price of non-core goods rather than through an increase in the nominal price of core goods and services.

So for a given stance of past, current and future monetary policy (as measured by the sequence of past, present and contingent future policy rates), relative demand and supply shocks that cause an increase in the relative price of non-core goods (the kind of shocks we are seeing globally today), will temporarily raise inflation above the level at which it would have been without these relative demand and supply shocks but with aggregate demand and supply at the same level. Such general price level blips work their way through the system quite swiftly; much of it is gone within a year, virtually all of it within two years. The do not ’cause inflation’.

In the Euro Area inflation has come down a little to 3.3 % year-on-year (on the inadequate HICP index, admittedly), from last month’s peak at 3.6%. For a central bank that aims at inflation in the medium term of below but close to 2 percent, this is not a great or even an acceptable performance. Unless the Euro Area level of activity slows down sharply, higher interest rates from the ECB cannot be ruled out.

Inflation in the US is running at 4.0 percent on the headline CPI inflation (which does include housing costs). This is way above what should be the Fed’s comfort zone. The die-hard core inflationists there will point out that core inflation is only 2.4%, but the only appropriate answer to that is: so what? Core inflation is of interest only to the extent that it is a superior predictor of future headline inflation. If it ever was, it has ceased to be so this millennium. The Fed has let inflation get away from it even more than the ECB and the Bank of England.

Even in Japan, inflation is positive again and rising.

In the BRICS, inflation is high and rising. China’s inflation rate just went up to 8.5 percent; and no, it’s not rice, chickens, pigs or energy, it’s inflation made by lax monetary policy in the short and medium term and a positive output gap in the short term. In fact, if we allow for inflation suppressed by price controls, the equivalent open inflation rate in China is probably above 10 percent. In Russia, inflation is well into double digits and rising. In India inflation is above 5 percent and rising. Only Brazil appears to have inflation reasonably steady at 4.73%, close to its target value.

Inflation is rising in countries that are tied to a weak currency, like the Gulf Cooperation Council States. Inflation is rising in countries tied to a strong currency. Latvia’s inflation rate came in at 17.8 percent. Inflation is rising in countries that have a floating exchange rate, like Iceland.

Central banks across the world have had it too easy for too long. It is time to bring inflation down to tolerable levels through appropriate restrictive policy. Fiscal tightening cannot reduce the short-run paid, but it can bias the composition of the necessary contraction in favour of the protection of investment. Unfortunaltely, both in the UK and in the US, discretionary stimuli instaed primarily support a still excessively buoy level of consumer demand.

As as regards those analysts and repporters who consider the inflation rate and inform you that, provided you exclude the bundles of goods and services whose prices have increased the most, the inflation rate of the rest is quite modest, cast them out, because they are not your frieds.

Conclusion

The oil price shocks of 1973/74 and of 1979/80 did not cause inflation. They caused a massive favourable terms of trade shock for oil exporters and a massive adverse terms of trade shock for oil importers. They also caused an adverse supply shock for all producers that used oil and its close substitutes as inputs into the production of non-oil goods and services. Without central bank accommodation and expansionary fiscal policy to try to undo the negative effects of the oil price shock on non-oil production and employment, there would at most have been a one-off increase in the general price level. Because everything takes time, this one-off increase would have shown up as a minor and temporary (probably less than 2 years in duration) increase in the rate of inflation.

We got in addition a large fiscal boost in the oil importing countries (adding a further one-off increase in the general prices level) and monetary accommodation by every central bank in the known universe, bringing us actual sustained increases in inflation.

The current commodity price increases (including oil and food) are mainly drivven by global demand growth rather than by major unexpected contractions of supply. This global demand growth (concentrated in the Emerging Markets) has outstripped even the formidable growth in potential output in the world economy (again mainly in the Emerging Markets). The inflation we are seeing world wide is the result of excessively expansionary monetary policy and the excessive credit growth is has created almost everywhere. Its solution will be globally tighter monetary policy (to different degrees in different countries) leading to lower global credit growth, a global economic slowdown (locally even to recessions) and ultimately lower inflation. This has been seen and done a hundred times. Only the scale and some of the players, like China, are different.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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