A nasty whiff of inflation

Global monetary policy

Sep 22nd 2005
From The Economist print edition

Thanks to higher oil prices, inflation is creeping up all around the world

INFLATION was supposed to be dead. Yet back-of-the-envelope estimates by The Economist suggest that in September America's 12-month rate of consumer-price inflation will jump above 4%—the highest since 1991. If so, this more than justifies the Federal Reserve's decision this week to raise its fed funds rate by another quarter of a percentage point, to 3.75%. Despite calls from several American politicians and economists for a “compassionate pause” in the Fed's tightening, because of fears that Hurricane Katrina could depress economic output, the Fed is more worried about the risk of higher inflation than about slower growth.

Average petrol prices in America fell back to $2.76 a gallon this week, from a peak of $3.07 a fortnight ago. However, the immediate path of prices is uncertain: Hurricane Rita, an even bigger storm that was heading for Texas this week, may well do further damage to America's Gulf coast refining capacity. Even without an extra push from Rita, the average price of a gallon in September will be well above that of last month, giving consumer-price inflation, already 3.6% in August, an extra fillip.

Petrol prices have also taken their toll on consumer confidence: the University of Michigan's index plunged in early September to its lowest level since 1992. The fall since July has been the largest two-month drop since records began in 1978. If the recent decline in petrol prices continues, however, consumers' fears should ease. The huge planned post-Katrina increase in government spending, of up to $200 billion, should help underpin the economy.

Much more alarming was the sharp jump in inflation expectations in the same survey.
Consumers now expect prices to rise by 4.6% in the coming year, having forecast 3.1% in August. Their guess for inflation over the next five to ten years rose to a four-year high of 3.1%, from 2.8%. Higher spreads on inflation-protected Treasury bonds and a rise in gold prices, to a 17-year high of $470 an ounce, also suggest that an increase in inflation is thought to be on the way.

The Fed signalled this week that it intended to keep pushing interest rates higher. Despite 11 increases since June 2004, monetary policy is still loose. Using August's inflation figure, real interest rates are barely positive, while bond yields are lower than before the Fed started to raise rates. Such monetary laxity has been fuelling America's housing bubble—and now it risks feeding wider inflation.

In its statement this week the Fed stressed that core inflation—a measure that excludes energy and food prices—has remained relatively low, at only 2.1% over the past year. The core inflation rate was invented in the 1970s as a way to exclude the impact of temporary food and oil supply shocks, and so allow the Fed to focus on the underlying trend. The snag is that the current rise in oil prices looks much more permanent than previous spikes. Moreover—at least until Katrina came along—the rise in world oil prices has mainly reflected strong demand (partly due to robust growth in America) rather than a disruption of supply, and may therefore be a symptom of more general inflationary pressures.

Stephen Roach, the chief economist at Morgan Stanley, worked at the Fed in the 1970s under the then chairman, Arthur Burns. He remembers the dangers of core inflation. When oil prices surged in 1973-74, Burns asked the Fed's economists to strip out energy from the consumer-price index (CPI) to get a less distorted measure. When food prices then rose sharply, they stripped those out too—followed by used cars, children's toys, jewellery, housing and so on, until around half the CPI basket was excluded because it was supposedly “distorted” by exogenous forces. As a result, the Fed failed to spot the breadth of emerging inflationary pressures throughout the economy.

Lesson learned

It looks unlikely to make the same mistake this time. Companies are already passing on some of their higher fuel costs. In recent weeks, airlines and delivery firms have raised fuel surcharges. Dow Chemical has announced price increases for all of its chemical and plastic products.
Businesses are also facing rising labour costs. Unit labour costs rose by 4.2% in the year to the second quarter, as productivity slowed and wage growth picked up. A year earlier unit labour costs were actually falling. Adding all this together, David Malpass, an economist at Bear Stearns, forecasts that the annual rate of core inflation could reach 3% in the coming months.

It is not only America that is experiencing creeping inflation. Economists at CSFB forecast that higher oil prices will push the euro area's inflation rate up to 2.6% this month. That may not sound so bad, especially when core inflation still remains well below the 2% ceiling of the European Central Bank's (ECB) target. However, the euro area's official inflation rate probably understates reality, because it excludes the costs of owner-occupied housing. Adding these in would probably push this month's inflation rate above 3%.

This weakens the case of those clamouring for the ECB to cut interest rates from their current 2%. Real interest rates in the euro area are already negative, and now, with inflation moving up, the ECB is even less likely to ease policy.

CSFB is also betting that Britain's inflation rate will rise to 2.8% in September, its highest since 1995 and well above the Bank of England's 2% target. This appears to vindicate the vote by Mervyn King, the Bank's governor, against August's quarter-point cut in interest rates to 4.5%. The minutes of the September meeting, published this week, showed that in its latest deliberations the rate-setting committee was unanimous in holding rates steady.

In Japan talk of inflation is still premature, but deflation may at last be coming to an end. The Bank of Japan and most private-sector economists expect the year-on-year change in the core CPI (which in Japan excludes only fresh food) to turn positive before the end of this year. The Bank of Japan has said that it will not tighten monetary policy until the core rate of inflation has been above zero for several months and is expected to stay there.

With inflation edging up almost everywhere, is there a risk of a repeat of the 1970s? A burst of double-digit inflation seems unlikely. Prices took off in the 1970s largely because of serious policy errors. Policymakers now understand that rising inflation harms growth, and independent central banks are more likely to stamp on inflation swiftly.

The real worry with rising inflation expectations is less that they herald a surge in inflation than that they will limit the ability of the Fed or other central banks to cut interest rates if growth stumbles. It is commonly argued in America that if the housing bubble were to burst, and falling house prices threatened to choke consumer spending, the Fed would slash interest rates to prop up the economy, as it did after the stockmarket bubble popped in 2001-02. But then inflation was falling. Today, with inflation rising, the Fed would no longer have that option. If the economy hits trouble, investors and homebuyers should not expect to be bailed out again.

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