Martin Wolf of the Financial Tmes focuses on the question of whether we are repeating the mistakes made in the 1970s, of entering a period of inflation due to overly accommodative monetary policy. Although he hesitates to reach a firm conclusion, he sees more evidence that commodities price rises are a function more of fundamental factors (rising demand and market-specific supply constraints) that money supply growth. But of course, the sort of across-the-board raw material price increases we’ve seen will fuel inflation (many would say it’s already started) and make central bankers’ jobs more difficult.
Some of Wolf’s observations have been trumped by events. He says, for instance, that Treasury Inflation Protected Security prices as of last week showed that inflation expectation are “well contained.” This week, five year TIPS traded at negative yield, reflecting a buying panic. Wolf also says that commodities prices are not a function of speculation; otherwise, inventories would be soaring. That may not be quite as true as Wolf believes.
From the Financial Times:
Soaring commodity prices, rising headline inflation and weakening economic growth: for those whose memories stretch back to the 1970s, this combination brings painful memories. It reminds them of the mistakes made by the central banks that accommodated the upsurge in inflationary expectations rather than contained them. Inflation was finally brought back under control in the early 1980s. But the costs of letting it escape were huge. Could we be making the same mistakes again?
Every week, 50 of the world’s most influential economists discuss Martin Wolf’s articles on FT.com
In the US, headline consumer price inflation was 4.3 per cent in the year to January. In the eurozone, it was 3.1 per cent in the year to December 2007. In both cases, there was a gap – in the case of the US, a huge gap – between the headline rate and the “core” rate, which strips out volatile prices of energy and food.
If this were a temporary deviation, one would ignore it. But it has been continuing for years, particularly in the US (see chart). A cynical observer might well conclude that the Federal Reserve threw caution to the wind years ago. That is what Arthur Burns, then Fed chairman, did in the early 1970s, under pressure from Richard Nixon, then president. Has that been happening again in recent years? The question is surely a fair one.
The proximate cause of the surge in headline inflation is the global rise in commodity prices. Over the six years to February 2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263 per cent and the agricultural index by 220 per cent. This, then, has been a broad surge in commodity prices, albeit after more than two decades of, first, falling and then stagnant prices.
A rise in the relative prices of commodities may reflect inflationary pressures. It may also cause inflation. But it is not itself inflation. Such a rise is also precisely what we are seeing. If one deflates the rise in commodity prices given above by the increase in the unit value of exports of manufactures from high-income countries, one obtains the following increases in real prices: 147 per cent for all commodities, 192 per cent for energy, 77 per cent for non-energy, 131 per cent for industrial metals and 104 per cent for agricultural commodities.
What we are seeing then is a global shift in relative prices, with commodities, particularly energy, becoming much more expensive, relative to manufactures. If one deflates the price of crude oil in the same way, it is more expensive than at any time since 1970.
What is behind these surges in commodity prices? The big story is the impact of emerging economies and, overwhelmingly, of China, which has accounted for the bulk of global incremental demand for industrial raw materials. Between 2000 and 2006, it also generated 31 per cent of global incremental demand for oil, against just 20 per cent for North America.
The strength of demand in emerging economies does not entirely explain the rise in commodity prices. Mandates to produce biofuels have also had an impact on demand for some agricultural commodities. Also important have been constraints on supply: bad harvests, inadequate investment and higher costs. The rising price of energy is itself a big reason why agricultural production has become far more expensive. Speculation seems not to be that important. If it were, inventories would be soaring. But they are not.
Because of the steep fall in the value of the dollar against the euro, any given rise in global commodity prices will have a bigger impact on headline inflation in the US than in the eurozone and the other economies with relatively strong currencies. It is not surprising, therefore, that the gap between headline and core inflation has been particularly large there.
What then does a big rise in relative prices of commodities mean for the proper conduct of monetary policy? It will raise measured inflation. It will also tend to shrink the output of commodity-using sectors, aggregate real incomes and real demand. Which of these effects will predominate is unclear. Given these uncertainties, the right monetary policy response is also unclear. But the general rules are not.
Those rules are three: first, central banks must remind the public that monetary policy cannot give them back the real incomes that higher commodity prices have taken away; second, the banks must ignore what seem temporary fluctuations in relative prices, since a response would generate unnecessary economic instability; and, finally, they should respond to prolonged and continuing rises in relative prices. If they do not do so, upward shifts in inflation expectations and the inflation-risk premium in interest rates are likely.
Such upward shifts would have bad real effects. They would mean, not least, that a policy of aggressively lowering short-term rates in response to a perceived crisis, as in the US today, may fail. As Richard Fisher, president of the Federal Reserve Bank of Dallas noted in a speech delivered in London on Tuesday: “Since the January federal open market committee meeting, longer-term rates, including those on fixed mortgages, have risen rather than followed the federal fund rates downward.” In such circumstances, aggressive monetary policy may have weak, even perverse, effects on the real economy.
In the US today, inflation expectations are on a knife edge. As I noted last week, the expectations shown in the relation between inflation-indexed treasuries (TIPS) and conventional bonds appear to be quite well contained. But the Cleveland Fed offers a “liquidity adjusted series”, which allows for the desire to hold more liquid assets in a period of financial stress. On this measure, expected inflation is soaring (see chart). The Fed’s position is now uncomfortable. The assumption that it can cut rates without fear of the consequences is wrong.
If central banks are confident that commodity prices will now stop rising, or even fall, they should slash rates in response to any prospects of serious economic weakness. But, given the continued rapid growth of emerging economies, they cannot be sure of that. Worse, core inflation itself seems already to be drifting upwards.
My guess is that the right policy lies between the Fed’s one of doing everything possible to eliminate downside risks and the European Central Bank’s one of masterly inactivity. Yet we do not know. The reason for that is clear: for the first time in a quarter of a century, the background for monetary policy has become difficult. But of one thing I am certain: responsible central banks would not risk a return to the 1970s.