Wednesday, July 30, 2008

Fueling Inflation, Maintaining Imbalances

Mark Gertler recently asserted the United States should "not act rashly over inflation" fears. He argued that the recent jump in U.S. inflation is the result of relative price changes in food, energy, and other commodities and not the consequence of policy-induced aggregate demand pressures. Mark Thoma concurs and notes that since relative price changes provide "important signals to the economy about where resources are needed most and about the opportunity costs of employing them...we don't want to mute those signals..." In short, negative supply shocks are the source of the recent inflationary pressures and are not the type of price shocks that should be addressed by policy (unless they add momentum to a growing inflationary spiral--something the two Marks do not see happening).

This interpretation, however, begs the question of why these commodity are soaring in the first place? Could it be that in addition to the usual suspects--increased Asian demand, biofuel distortions, speculators--that loose U.S. monetary policy is playing a part? Given the monetary hegemon role played by the Federal Reserve--its monetary policy gets exported to all those countries pegged to the dollar--it seems reasonable to conclude that some of the increase in commodity prices are more than relative price changes; they are in part the result of policy-induced aggregated demand pressures. That is what I was thinking, anyhow, when reading Gertler's article. I was not alone in my thinking. Ken Rogoff makes a similar case in the FT:
As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.


In the light of the experience of the 1970s, it is surprising how many leading policymakers and economic pundits believe that policy should aim to keep pushing demand up. In the US, the growth imperative has rationalised aggressive tax rebates, steep interest rate cuts and an ever-widening bail-out net for financial institutions. The Chinese leadership, after having briefly flirted with prioritising inflation (expressed mainly through a temporary acceleration in renminbi appreciation), has resumed putting growth as the clear number one priority. Most other emerging markets have followed a broadly similar approach.

Dollar bloc countries have slavishly mimicked expansionary US monetary policy, even in regions such as the Middle East, where rapid growth is putting huge upward pressure on inflation. Of the major regions, only Europe, led by the European Central Bank, has resisted joining the stimulus party so far. But even the ECB is coming under increasing domestic and international political pressure as Europe’s growth decelerates.

Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation.
Rogoff goes on to address Gertler's claim that the Fed should more concerned about the financial crisis than the inflationary pressures:
What of the ever deepening financial crisis as a rationale for expansionary global macroeconomic policy? It is hard to see the argument in emerging markets where inflation is raging, but even in epicentre countries it is becoming increasingly dubious. Inflation stabilisation cannot be indefinitely compromised to support bail-out activities. However convenient it may be to have several years of elevated inflation to help bail out homeowners and financial institutions, the gain has to be weighed against the long-run cost of re-anchoring inflation expectations later on.
Another consequence of this pump-priming aggregate demand was recently mentioned by Brad Sester:
The [U.S.] policy response to the subprime crisis has avoided the sharp adjustment that many feared. But it also meant that many of the underlying imbalances haven’t really corrected. The composition of the US current account deficit has changed – the oil deficit is bigger, the non-oil deficit is smaller; the fiscal deficit is bigger and aggregate deficit of households is smaller - but the aggregate deficit remains large. And the rest of the world’s imbalances haven’t corrected either. China’s economy remains unbalanced. The oil surplus has gotten bigger.

Hence it is possible to argue — see Yves Smith — that risks are still increasing.
So in addition to potentially unanchoring inflationary expectations, U.S. policy--with help from foreign governments--has put off for another day the inevitable correction of economic imbalances.

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