Thursday, April 10, 2008

What Inflation?

From the WSJ:

Inflation is back.

After several years of relative stability, a wave of rising prices is washing over the world economy.

It comes at a most inconvenient time. The Federal Reserve is sharply cutting U.S interest rates -- the opposite of the usual response to rising inflation -- to prevent the housing bust and credit crisis from causing a deep, prolonged recession. That's making the global response to inflation more complicated.


On Wednesday, the World Bank estimated global food prices have risen 83% over the past three years, threatening recent strides in poverty reduction. The IMF forecast consumer prices in emerging and developing countries will rise 7.4% this year, the most inflation since 2001 though still well below the double-digit levels of the recent past.


But the fact that inflation is rising almost everywhere suggests some of its causes are global. As crops are sold for alternative-energy production, food prices have soared: The price of rice, the staple for billions of Asians, is up 147% over the past year. Increasing demand for natural resources among developing economies such as India and China has pushed up prices for raw materials world-wide. Oil-supply constraints have sent crude-oil futures surging above $112 a barrel Wednesday, a new record, resulting in rising fuel and transportation prices.

The weakening U.S. dollar is another source. Not only is it pushing up prices of American imports, it is transmitting inflation to the dozens of economies that link their currencies to the U.S. dollar, from Saudi Arabia to Hong Kong to Mongolia. Because of their currency pegs, these economies are forced to track Fed rate cuts even if they aren't facing recession. That is putting upward pressure on their prices. Additionally, years of easy credit earlier this decade -- the result of a global quest to avoid falling prices, or deflation -- are a contributing factor.

We've been talking about this trend for some time now. Here's what the Fed saw in their latest minutes:

In the United States, the headline CPI continued to rise rapidly in January but was flat in February. For those two months on average, the rate of headline inflation was down significantly from its elevated level in the fourth quarter of 2007, as retail energy prices stopped rising and core inflation moderated a bit; these two factors more than offset an acceleration of food prices. However, the increase in world petroleum prices in early March pointed to a renewed burst of energy price inflation in the near term. Available information, including producer prices for February, suggested that prices of core personal consumption expenditures (PCE) moved up a bit more slowly than the core CPI in January and somewhat faster than the core CPI in February. Household survey measures of expectations for year-ahead inflation jumped in March to their highest levels in about two years; in contrast, survey measures of longer-term inflation expectations were unchanged or up slightly.

And here's what they saw in their latest policy statement:

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

So -- what does all of this mean?

First, this is not going unnoticed. At the policy level that is extremely important. Once the inflation genie gets out of the bottle it's incredibly difficult to get back in. The last thing anybody wants is to play catch-up to inflation.

Secondly, the Fed is in a terrible policy bind. On one hand, they have an economy to mend and a financial system to fix. Central to fixing both is greasing the wheels of capitalism, which means lowering interest rates. But that helps to encourage inflationary growth at a time when inflation is already increasing.

Third, the US is no longer the world's only leading consumer of raw materials. As such, a slowdown in US demand won't be the world-wide cure all for spiking inflation. We have to rely on India and China to deal with their respective inflationary levels.