Authors: Stephen D. King
Who was right?
In ‘real time’, it was never that obvious.
To see why, it’s worth disentangling real and monetary drivers of inflation in industrial countries.
So far I have argued that ‘real’ effects on inflation stemming from emerging economies can play havoc with monetary policy decisions.
Rises or declines in commodity prices as a result of substantial changes in emerging economic prospects should not automatically be met by an interest rate response.
As the price level moves in relation to the level of wages and profits, people’s spending power adjusts to new economic realities.
What happens, however, if the inflation imported from the emerging world is not a reflection of real factors but, instead, a consequence of monetary misjudgements?
What happens if the imported inflation is of the Blefuscucian variety?
Emerging economies have problems with inflation.
First, they’re not helped by their track records.
Financial markets have long memories: it wasn’t so long ago that many emerging markets suffered from hyper-inflations, currency crises or both.
Look at Latin America in the 1970s and 1980s.
Second, given low levels of per-capita incomes, policymakers in emerging economies are often reluctant to slam on the brakes to prevent inflation from shooting upwards.
Third, policymakers often attempt to ‘hide’ inflation by offering subsidies on basic items such as food and energy, typically to protect those in rural poverty.
Fourth, for many emerging economies, the appropriate framework for conducting monetary policy has yet to be discovered.
In the absence of any credible domestic arrangement, most policymakers instead choose to jump into bed with a central bank that does appear to know what it’s doing.
Typically, it’s the Federal Reserve.
It’s not always a match made in heaven.
In the developed world, inflation targeting isn’t easy.
It’s much more difficult in the emerging world.
Volatile food and energy prices, typically ignored by a Federal Reserve that prefers to focus on core inflation, are much more important in the emerging world.
These countries are poor.
Their people spend a large amount of their income on the basics.
Put another way, unforeseen movements in volatile food and energy prices can send inflation in emerging markets all over the place.
One minute, inflation is roaring ahead, the next prices are collapsing.
Inflation targeting in this environment is rather meaningless.
It’s like aiming at a dartboard made of mercury: the target is constantly moving and the policy darts simply won’t stick.
It’s for this reason that many emerging economies choose not to commit solely to an inflation target.
But they still need to show they support the principles of ‘sound money’.
Lenin allegedly said that the best way to undermine the capitalist system was to debauch the currency.
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Some emerging economies have done so in the past with considerable aplomb.
Nowadays, however, many emerging economies support the aims of sound money by tying their currencies, loosely or tightly, to the US dollar.
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After all, the Federal Reserve has delivered sound money over many years.
Maybe, through their ties to the US dollar, other countries might be able to do the same.
One problem with this approach is the possible inconsistency between an exchange-rate target and domestic price stability.
Emerging economies are, for the most part, enjoying an extended period of economic ‘catch-up’, whereby their per-capita incomes gravitate towards higher levels in the developed world.
This, though, creates a possible problem known as the Balassa–Samuelson condition.
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Typically, productivity gains for fast-growing economies are to be found in the tradable goods sector, where cutting-edge technologies can be most easily deployed.
Wages begin to rise in these productive areas, as the benefits of rapid growth begin to trickle down into the population at large.
But if wages are rising in the increasingly productive areas of the economy, what happens to wages in areas where productivity hasn’t moved an inch?
What happens to the incomes of hairdressers, waiters, taxi drivers and the like?
According to Balassa–Samuelson, their wages also rise.
They need to, in part, because otherwise everyone would rush off to the super modern factories, leaving restaurants bereft of staff and the population as a whole with very long hair.
If wages rise in line with productivity gains, nothing very much happens to inflation.
People are paid more, but they’re also
producing more, so the cost per item produced doesn’t change very much.
If, instead, wages rise faster than productivity gains (and, for taxi drivers in heavily congested cities, this is likely to be a fact of life), inflation will rise.
Across the emerging world, the desire to link currencies to the US dollar inevitably implies upward pressure on inflation as the taxi drivers, waiters and hairdressers benefit from productivity gains in other parts of the economy.
There is nothing wrong with this process.
It is an essential part of economic catch-up.
As people become richer, their domestic wages rise.
This, in turn, increases their purchasing power over goods and services priced in foreign currency.
It’s one reason why global commodity prices have tended to rise since the late 1990s.
As people become richer, their command over global resources tends to rise.
In the emerging world, however, not all people get richer at the same pace.
As I shall explain in more detail in Chapter 6, levels of income inequality are remarkably high.
China, for example, has a level of income inequality similar to that of the US, an ironic result given the countries’ differing political systems.
In an attempt to deliver social cohesion in the light of rising commodity prices, many fast-growing emerging markets choose to subsidize the prices of staples such as food and energy.
This effectively raises consumption over and above the market clearing level.
Higher consumption in the emerging world must, though, imply lower consumption elsewhere: the developed world ends up paying an even higher price for access to the world’s raw materials.
Inflation in the emerging markets may tend to drift higher as a result of economic catch-up accompanied by fixed nominal exchange rates, but there is also a danger of nasty inflation surprises that stem from emerging-market linkages to the US dollar.
These surprises are not confined to the emerging world alone.
When the Federal Open Markets Committee (FOMC) sits down every six weeks in Washington DC to debate the appropriate level of US interest rates, there’s very little discussion about anything other than the outlook for the US economy.
A quick glance through the published minutes of the numerous meetings held since the 1990s reveals that there’s no time for a detailed discussion of what’s going on in emerging economies.
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On occasion, they are considered important, but only because they sometimes provide a clear and present danger to the US economy.
Their day-to-day problems are really of no concern to the august members of the FOMC.
Yet the Federal Reserve’s decisions have a direct impact on many emerging economies precisely because these countries link their currencies to the dollar.
If the Fed chooses to cut interest rates, emerging-market central banks may have to follow suit.
Otherwise, their currencies will tend to rise against the dollar.
The same arguments apply, in reverse, if the Fed chooses to raise interest rates.
The Fed ends up setting monetary conditions in a dollar bloc that spreads far and wide around the world.
This might not matter if most emerging economies’ business cycles were tied to the US business cycle because, in those circumstances, Fed policy that was good for the US goose would also be good for the emerging-market gander.
But emerging-market business cycles are not perfectly linked with the US.
In the late 1990s, at the time of the Asian crisis, the US economy was booming.
In the early years of the twenty-first century, when the US economy was struggling to cope with the consequences of the collapse in its late 1990s technology bubble, emerging markets were booming.
Consider once again the linkages between US monetary policy and monetary conditions in emerging markets.
If the US economy is
relatively weak, the Federal Reserve will naturally have a bias towards ‘easy’ monetary policy.
Indeed, in 2003, Fed funds, the key US policy rate, fell to just 1 per cent, a remarkably low number compared with earlier history.
The dollar came under tremendous downward pressure as investors pulled their savings out of the US to hunt for returns elsewhere in the world.
A lot of money poured into the emerging markets.
In a world of flexible exchange rates, emerging-market currencies should have risen rapidly.
Some of them, for example the Brazilian real, did (although the real’s increase eventually proved too much for the Brazilian authorities, who eventually had to intervene in the foreign-exchange markets to prevent further appreciation in an attempt to keep exporters happy).
Most of them did not.
In the absence of any other nominal anchor, and with a fear of lost export opportunities, the majority of emerging economies resisted exchange-rate appreciation.
Like Muhammad Ali in the rumble in the jungle, they merely absorbed the pressure.
But, rather than sitting on the ropes being pummelled by George Foreman, they instead allowed their foreign-exchange reserves to rise.
This approach had two broad consequences.
First, resistance to exchange-rate appreciation meant that emerging economies were left with too much money swilling around, the result of low interest rates and high foreign-exchange reserves.
Arguably, the rapid increases in emerging-market domestic demand which followed contributed to huge gains in commodity prices.
Second, because foreign-exchange reserves were heavily invested in ‘low-risk’ dollar assets, notably Treasuries, the price of these assets went up and the yield came down, as explained in Chapter 4.
Put another way, although the Federal Reserve maintained control over short-term interest rates, it increasingly lost control of the longer-term interest rates that matter for businesses and households.
The same applied in the UK where, as noted earlier, rising official interest rates were associated with falling
yields on junk bonds.
The global housing boom of recent years was partly the result of this distortion in the level of interest rates.
Other countries also lost their grip on the monetary reins.
Low interest rates in the US, combined with even lower interest rates in Japan and relatively high risk in some of the emerging markets, persuaded many investors to take advantage of so-called carry trades, borrowing in dollars or yen and reinvesting in higher-yielding currencies like sterling, the New Zealand dollar and the Icelandic krona.
The resulting inflows allowed the banking systems of these countries to expand rapidly, seemingly beyond the control of central bankers and regulators.
Indeed, the more central banks raised their interest rates to contain inflationary pressures, the bigger the carry trade.
And, as commercial banks found themselves awash with liquidity from abroad, so they loosened their lending terms.
The housing boom spread like wildfire through the Western banking system in part because individual central banks were powerless to stop the domestic consequences of carry trades and, more broadly, return-hungry international capital flows.
Four broad conclusions follow.
First, the arrival on the world stage of the new economic superpowers has made the interpretation of price movements much more difficult.
Inflation can go up and down for non-monetary reasons and, on some occasions, a monetary response is neither necessary nor desirable.
The gravitational pull exerted by the new powers, whether to raise or lower inflation, may be related to ‘real’ economic factors such as beneficial productivity shocks or unhelpful commodity-price shocks.
Central bankers who tweak interest rates in the hope of limiting the inflationary consequences of these effects may, in fact, be doing the wrong thing.
Second, the successful pursuit of price stability provides no guarantee of lasting economic stability.
History is replete with periods of low and stable inflation followed by economic meltdown (the 1930s Depression followed a period of remarkably well-behaved US inflation in the 1920s, for example).
A failure to understand the relative consequences for the levels of wages and prices in the developed world of the increased influence of the emerging economies on labour and commodity markets threatens to encourage persistent errors in the calibration of monetary policy.
There are occasions when the price level needs to adjust in relation to the level of wages and profits.
Using interest rates to prevent this mechanism from working risks heightened economic instability.