Fed bets its unwelcome visitor will march out
May 13, 2008
By Michael Sesit
Among the world's two major central banks, the US Federal Reserve is stuck somewhere between steps one and two, while the European Central Bank (ECB) is firmly residing at the second option, warning that it might advance to the third.
At 4 percent, US inflation threatens to undermine the credibility of a central bank that has cut interest rates seven times to 2 percent from 5.25 percent over the past eight months, in an attempt to keep the American economy growing. Meanwhile, the ECB has left rates unchanged at 4 percent since last June. Euro zone inflation was 3.3 percent last month, compared with the ECB's target of below 2 percent. In March it was 3.6 percent, almost a 16-year high.
The dilemma for investors is whether prices will climb still faster, or whether slowing growth and the credit crunch will slay the inflation dragon.
The good news is that inflation may not turn out to be as bad as the pessimists think. The bad news is there's probably not much that central bankers can do anyway.
It's important to differentiate between a general increase in prices - a situation in which the cumulative demand for goods and services exceeds their aggregate supply - and a relative price shock. The latter reflects a sudden change in the demand or supply of particular goods or services. Take higher energy prices: they are a product of rising demand for crude oil, dwindling petroleum supplies and geopolitical risks.
"Generalised inflation can be cured by active demand management via tighter monetary policy," says Chen Zhao, a global strategist for BCA Research. "However, neither monetary nor fiscal policy is effective in dealing with a relative shock … No country can bring down oil or food prices by compressing aggregate demand through aggressive monetary policy tightening."
A specific price shock can become generalised if producers are able to pass on the higher costs. So far, global competition has made that difficult for companies, while higher input costs have largely been neutralised by rising labour productivity and corporate efficiencies. Since 2003, core inflation, which excludes food and energy, has averaged less than 2 percent a year in the 30 member states of the Organisation for Economic Co-operation and Development.
Slowing US growth, consumer indebtedness, a flexible labour market and an economy that is open to foreign competitors should constrain demand and prevent firms from raising prices.
And history shows that bursting asset bubbles are deflationary. They lift unemployment and retard income growth.
The euro zone suffers from labour market rigidities that fuel weak growth and accelerating inflation. The region's growth has underperformed the US for a decade.
Emerging Asia is the outlier: surging energy and food prices are sending headline inflation higher. Yet core inflation has begun to climb as a result of low interest rates, undervalued currencies, expanding trade surpluses, large foreign exchange reserves and a pick-up in consumer spending.
Still, inflation is tempered by Japan's persistent deflation and by intense competitive pressures that have forced the likes of South Korea, Singapore and Taiwan to shed manufacturing. And although Chinese exports are becoming more expensive, they will still push global prices lower.
"Netting it all out, it seems that the whole world is converging towards 2 percent to 3 percent inflation," Chen says.
History suggests that the Fed's gamble that slowing growth will shackle core inflation is a winning wager. The risk is that if US consumers don't believe price increases will slow, growing inflation expectations may become self-fulfilling. If so, the restaurant will need a bigger bouncer.
Michael Sesit is a Bloomberg columnist
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