Friday, October 31, 2014

The Exaggerated Death of Inflation

CAMBRIDGE – Is the era of high inflation gone forever? In a world of slow growth, high debt, and tremendous distributional pressures, whether inflation is dead or merely dormant is an important question. Yes, massive institutional improvements concerning central banks have created formidable barriers to high inflation. But a significant part of a central bank’s credibility ultimately derives from the broader macroeconomic environment in which it operates.

In the first half of the 1990s, annual inflation averaged 40% in Africa, 230% in Latin America, and 360% in the transition economies of Eastern Europe. And, in the early 1980s, advanced-economy inflation averaged nearly 10%. Today, high inflation seems so remote that many analysts treat it as little more than a theoretical curiosity.

They are wrong to do so. No matter how much central banks may wish to present the level of inflation as a mere technocratic decision, it is ultimately a social choice. And some of the very pressures that helped to contain inflation for the past two decades have been retreating.

In the years preceding the financial crisis, increasing globalization and technological advances made it much easier for central banks to deliver both solid growth and low inflation. This was not the case in the 1970s, when stagnating productivity and rising commodity prices turned central bankers into scapegoats, not heroes.

True, back then, monetary authorities were working with old-fashioned Keynesian macroeconomic models, which encouraged the delusion that monetary policy could indefinitely boost the economy with low inflation and low interest rates. Central bankers today are no longer so naive, and the public is better informed. But a country’s long-term inflation rate is still the outcome of political choices not technocratic decisions. As the choices become more difficult, the risk to price stability grows.

A quick tour of emerging markets reveals that inflation is far from dead. According to the International Monetary Fund’s April 2014 World Economic Outlook, inflation in 2013 reached 6.2% in Brazil, 6.4% in Indonesia, 6.6% in Vietnam, 6.8% in Russia, 7.5% in Turkey, 8.5% in Nigeria, 9.5% in India, 10.6% in Argentina, and a whopping 40.7% in Venezuela. These levels may be a big improvement from the early 1990s, but they certainly are not evidence of inflation’s demise.

Yes, advanced economies are in a very different position today, but they are hardly immune. Many of the same pundits who never imagined that advanced economies could have massive financial crises are now sure that advanced economies can never have inflation crises.

More fundamentally, where, exactly, does one draw the line between advanced economies and emerging markets? The eurozone, for example, is a blur. Imagine that there was no euro and that the southern countries had retained their own currencies – Italy with the lira, Spain with the peseta, Greece with the drachma, and so on. Would these countries today have an inflation profile more like the United States and Germany or more like Brazil and Turkey?

Most likely, they would be somewhere in between. The European periphery would have benefited from the same institutional advances in central banking as everyone else; but there is no particular reason to suppose that its political structures would have evolved in a radically different way. The public in the southern countries embraced the euro precisely because the northern countries’ commitment to price stability gave them a currency with enormous anti-inflation credibility.

As it turned out, the euro was not quite the free lunch that it seemed to be. The gain in inflation credibility was offset by weak debt credibility. If the European periphery countries had their own currencies, it is likely that debt problems would morph right back into elevated inflation.

I am not arguing that inflation will return anytime soon in safe-haven economies such as the US or Japan. Though US labor markets are tightening, and the new Fed chair has emphatically emphasized the importance of maximum employment, there is still little risk of high inflation in the near future.

Still, over the longer run, there is no guarantee that any central bank will be able to hold the line in the face of adverse shocks such as continuing slow productivity growth, high debt levels, and pressure to reduce inequality through government transfers. The risk would be particularly high in the event of other major shocks – say, a general rise in global real interest rates.

Recognizing that inflation is only dormant renders foolish the oft-stated claim that any country with a flexible exchange rate has nothing to fear from high debt, as long as debt is issued in its own currency. Imagine again that Italy had its own currency instead of the euro. Certainly, the country would have much less to fear from an overnight run on debt. Nevertheless, given the huge governance problems that Italy still faces, there is every chance that its inflation rate would look more like Brazil’s or Turkey’s, with any debt problems spilling over faster price growth.

Modern central banking has worked wonders to bring down inflation. Ultimately, however, a central bank’s anti-inflation policies can work only within the context of a macroeconomic and political framework that is consistent with price stability. Inflation may be dormant, but it is certainly not dead.

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  1. CommentedRoger McKinney

    Higher inflation in the West will require governments ramping up borrowing and spending. Businesses aren't going to do it. The high inflation in the US during the 60s and 70s resulted from massive regulation that reduced supply and massive government spending.

  2. CommentedDavid Joki

    I have a few complaints. First, the analysis is superficial in its' economics. Inflation of 40.7% in Venezuela is nothing at all like the other countries listed. And of those only Argentina is listed above 10%. Second, the fear that always lies behind alarming inflation data is the chance of hyperinflation. Paul Krugman has asserted that hyperinflations are almost always associated with political breakdown, massive corruption, and wars. How many of the 12% and below countries are facing that now? None are facing large wars now. And, he does not mention the harm that prices falling in maybe up to half of an economies industries ( which can happen when inflation sinks to sub 2 % levels) can cause. Really a superficial piece and not at all the quality of thinking that I come to Project Syndicate for.

  3. CommentedSean O'Leary

    Mr. Rogoff on the subject of inflation in March 2008 in a piece titled "Inflation Reality Check":
    "The U.S. is now ground zero for global inflation. Faced with a vicious combination of collapsing housing prices and imploding credit markets, the Fed has been aggressively cutting interest rates to try to stave off a recession.

    But even if the Fed does not admit it in its forecasts, the price of this ``insurance policy" will almost certainly be higher inflation down the road, and perhaps for several years."

  4. CommentedJesus Carrillo

    Mr Rogoff is starting from the wrong point. His first question is "Is the era of high inflation gone forever?". Not indeed. As you can read in his article, there's just one country with inflation above 10%: Vzla. But, this country is a basket case, as anybody knows. And about the hypothetical rate of inflation among the southern countries of the Eurozone, he should remember that the creation of the euro, was preceded by low levels of inflation in all the member countries. And the option of thinking about "What if...", in the case of keeping the national currencies today, is out of the question. The European countries' inflation is below the rate in emerging countries. This has always been the case. This article looks like an "argument" to leave the euro, searching for inflation levels, instead of the deflation We have now. Pointless.

  5. CommentedPetros Theodorou

    Are you sure that inflation in peripherals like greece is low? Because no matter what cpi indicates super market prices are still increasing. Moreover, the price level is very high taking into account ppi even if rythm is low

  6. CommentedThomas Herr

    Who exactly is saying inflation is dead? I know a number of people who are saying that the threat of deflation in certain countries, especially Europe, is greater than the threat of inflation. I don't know anyone of repute who is saying deflation is dead. This is just setting up a straw man to stoke the fear of inflation and push a well-known policy agenda.

  7. CommentedBob Kostakopoulos

    It is silly to assert that high inflation is gone forever. Just as silly as the assertion that the business cycle has been eliminated or that financial crises have been legislated out of existence (Dodd-Frank Act).
    However, economic policy operates in real time. Policy makers pay attention to the facts on the ground. To raise the specter of high inflation once again is a detraction that undermines what the enlightened Fed Chairwoman Yellen is trying to do.

  8. CommentedRalph Musgrave

    Rogoff is a waste of space. It's blindingly obvious that if government engineers an excessive increase in demand and/or the money supply, then inflation will rear its ugly head. Next he'll be telling us that a poor harvest is a possibility, or that a severe Winter is a possibility.

      CommentedRobert Lunn

      Might be a waste of space as he's taking a shot at Krugman; who often said that Greece would/could not default with its currency.
      I wish they would spend some time looking at the market punishing high debt nations through strong. currency. It's not a new argument obviously but would be refreshing as nobody talks about it now.

  9. CommentedPaul Hodges

    Ahem. "Modern central banking has worked wonders to bring down inflation." This is rather like saying that the SuperBowl indicator really does predict the direction of Wall Street.

    As Paul Volcker has noted a number of times, "The basic function of a central bank is to defend the value of the currency.”

    The prime cause of the recent economic SuperCycle was not the genius of central bankers but the arrival of the BabyBoomers in their prime wealth creation years (the 25 - 54 period). They created the illusion of constant demand, as they joined the workforce, boosted supply, and created demand.

    But now they have joined the 55+ generation, when demand slows as people already own most of what they need, and their incomes decline as they enter retirement.

    So we are left with a supply surplus from the SuperCycle, coupled with a decline in growth levels.
    How this creates the possibility of inflation is a mystery to me!

  10. CommentedLance Brofman

    Most investors now believe three things about the Federal Reserve, money and interest rates. They think that the Federal Reserve is artificially depressing rates below what would be a "normal" level. They believe that in the process of doing so the Federal Reserve has enormously increased the supply of money and they believe that the USA is on a fiat money system.
    All three of those beliefs are incorrect. One benchmark rate that the Federal Reserve has absolute control of is the rate paid on reserves deposited at the Federal Reserve. That rate is now 25 basis points, after being zero since the inception of the Federal Reserve in 1913 until recently. If the Federal Reserve had left that rate at zero t-bill rates would now be even lower than they are now. The shortest t-bills rates would now be probably negative.
    Paying interest on reserves combined with the subsidy to the banks of providing free unlimited deposit insurance on non-interest bearing demand deposits is keeping t-bill rates positive. Absent those policies the rate on t-bills would be actually negative. The Chinese and others all over the world are willing to pay anything for the safety of depositing funds in the USA. Already, Bank of New York Mellon Corp. has imposed a 0.13% charge on large deposits.
    An investor who believes that interest rates are headed up may respond that the rate paid on reserves is a special case and that the vast increase in the money supply resulting from the quantitative easing must result in higher rates when the Federal Reserve reverses its course. The problem with that view is that the true effective money supply is still far below its 2007 level.
    Money is what can be used to buy things. Historically money has first been specie (gold and silver coins), then fiat money which is paper currency and checking accounts (M1) and more recently credit money. The credit money supply is what in aggregate can be bought on credit. Two hundred years ago your ability to take your friends out to dinner depended on whether or not you had enough coins (specie) in your pocket. One hundred years ago it depended on the quantity of currency in your pocket and possibly the balance in your checking account if the restaurant would take checks.
    Today it is mostly your credit card that allows you to spend. We no longer have a fiat money system. Today we have a credit money system. Just because there is still some fiat money does not negate the fact that we are on a credit money system. When we were on a basically fiat money system there was still a small amount of specie in circulation. Even today a five cent piece contains about 5 cents worth of metal, but no one would claim we are still on a specie money system.
    Fiat money is easy to measure; M1 was $1.376 trillion in 2007 and was $2.535 trillion in May 2013. The effective money supply is the sum of fiat money and credit money. Credit money cannot be precisely measured. However, When the person in California whose occupation was strawberry picker and who had made $14,000 in his best year was able to get a mortgage of $740,000 with no money down and private equity could buy a company like Clear Channel in a $20 billion leveraged buyout, also with essentially no money down, the credit money supply was clearly much higher than today. A reasonable ballpark estimate of the credit money supply is that it was $70 trillion in 2007 compared to $50 trillion today.
    The effective money supply is the sum of the traditional fiat money aggregates plus the credit money supply. Thus, despite the claims of Ron Paul and Rick Perry to the contrary, the effective or true money supply has fallen drastically over the last few years...."

  11. Commentedsteve from virginia

    Rogoff is disingenuous b/c 'inflation' can mean anything he wants it to mean.

    Inflationary spiral = both wages and goods' prices increasing stepwise with wages always following price increases.

    Today there are high prices in all countries due to creeping business monopolies, constrained (rigged) markets, costs overcoming economies-of-scale and effects of EROI (Energy Return on Investment). Real fuel prices are high because the energy investment required to gain fuel is constantly increasing ... and fuel is the constant factor in industrialization.

    Rogoff fixates on monetary policy not acknowledging that 'money' is nothing more or less than a claim against purchasing power which itself is a claim against capital ... capital being non-renewable resources. As resources are depleted in a rush, the claims -- more or less of them it matters not -- are stranded and are ultimately worthless.

    Whether claims are diluted (inflation) or are rendered superfluous (deflation) the outcome is the same = ruin.

    That's where we are all going, folks and there is nothing Rogoff can do about it.

  12. Commentedudi cohen

    two reasons- a lack of resources and interest rate that won't produce the right gap to ensure profit, will make inflation emerge. of course, taking into consideration as mentioned, technology advances that leads to growth of productivity.
    as i see it, globalization and technology got the economy into quantity thinking from - pricing (and quantity) and eventually to excess of supply which contain the inflation -for now !

  13. CommentedProcyon Mukherjee

    It would be apt, Mr. Rogoff, if we go back to Mr. Tobin's treatise written many years back, "Commercial banks as creators of Money" where he said, "If the economy and the supply of money are out of adjustment, it is the economy that must do the adjustment"; this is contradicted by you and many others that the adjustment process starts and ends with Central Banks.

  14. CommentedNathan Weatherdon

    As a modification of a recent argument with respect to the case of a recent German policy to raise minimum wages well above the EU average ... We could always resort to minimum wage hikes as a sort of temporary stimulus to inflation with desirable redistributional effects (according to historically high inequality) and also serving to "separate the chaff" of businesses which make inefficient use of labour, as it were, in pushing towards an ever more productive and prosperous future.

    As minimum wages across cities in China double, triple, and more, there are plenty of reasons to think that inflation could strike again, even in the absence of any rupture to global trading systems.

    I think many people are implicitly betting on inflation staying low, as observed through taking on mortgages and commercial debt which would not tolerate interest rates at double their current rates, which these days is barely a blip on the radar compared to many historical interest rate hikes. Should central banks be more tolerant of temporary spikes in inflation, or is that a disaster waiting to happen?