Thursday, February 10, 2011

Deflating Inflation Expectations

Talk of inflation seems to be everywhere these days.

Clients and analysts point to soaring commodity prices, including oil, that inflation is finally reappearing after years of being dormant. The bond market is also cited as sniffing inflationary pressures, since interest rates have risen in the last few weeks (but are unchanged from a year ago).

Still, I don't agree, and I thought Fed Chairman Bernanke did a good job yesterday discussing price pressures.

Bernanke (who is a pretty fair economist, after all) noted that most measures of inflation in the United States do not show any evidence of rising, but are certainly evident in the emerging markets:

"The inflation is taking place in emerging markets because that's where the growth is. That's where the demand is. And that's where, in some cases, the economies are overheating."

In the U.S., on the other hand, there is too much excess capacity, and too many unemployed workers, for any serious inflationary pressures to take place.

That was the point also raised by The Economist on its blog. Not only does the magazine dismiss the idea that the U.S. (or the U.K., for that matter) should be concerned by rising commodity prices, it also argues that any premature tightening of monetary policy could have disastrous consequences:

Just as the plunge in the price of oil in 1998 did not signal deflationary pressure in America, its rise today does not signal inflationary pressure here, unless it works its way into expectations and wages, of which there’s no sign yet...

...In fact, it could do the opposite: by draining more American purchasing power to overseas suppliers, higher oil prices leave less money to spend on stuff made in America. (America is a net food exporter so higher food prices are positive for American growth.) If the Fed were to tighten monetary policy today in response to Asia’s inflation problem, it could be the opposite of the mistake it made in 1998, compounding a deflationary shock at a time when the economy is significantly below potential.

Commodity prices: Inflation lessons from the Asian crisis | The Economist

Inflation can be a scary thing for the economy, and it is right that policy makers remain vigilant to make sure that we do not return to the high inflation days of the 1970's.

On the other hand, deflation can be even worse - just look at Japan, which remains stuck in an economic malaise that has now lasted more than 20 years. Premature tightening of monetary policy in Japan has occurred several times over the last couple of decades, and each time the policy changes had to be reversed.