Wednesday, Mar 03, 2004
In the past, inflation tended to disappear for decades and then suddenly return with a vengeance. The causes for the apparent death of inflation in the 1990s were low commodity prices, high productivity growth, product market deregulation and the direct price effects of cheap imports from Asia. There have been a number of warning signs of late that this golden scenario may have begun to come to an end.
One is the steady rise in commodity prices, a frequent but not always accurate harbinger of future inflation. The prices of many raw materials and gold have been rising robustly over the past year. The trend in the oil price is also upwards. The news that Nigeria and Algeria have ordered oil companies to cut production quotas is an indication that the Organisation of Petroleum Exporting Countries may be getting serious about the plans it announced last month to cut oil production by 1m barrels a day.
In Asia, meanwhile, the period of deflation has been coming to an end almost everywhere except in Japan and Taiwan. China, for example, reported an inflation rate of 3.2 per cent in January, ending five years of price deflation. The reasons include rising domestic food prices, a surge in demand for raw materials and an increase in transport costs resulting from severe shortages in shipping capacity. There are no overt signs of labour market inflation, given China's seemingly endless supply of cheap labour. But, as several sectors are close to overheating, the likelihood of a further increase in inflation cannot be easily dismissed.
The question arises whether the world can shrug off Asia's return to positive inflation rates at a time of rising commodity prices. Europe, including the UK, will probably be less affected given the relatively conservative monetary policies of the European Central Bank and the Bank of England.
More at risk is the US. During the 1990s, the US managed a low rate of inflation despite a positive output gap. But many of the factors that caused the apparent death of US inflation have gone into reverse. With short-term interest rates at 1 per cent, the Federal Reserve's monetary policy stance is highly expansionary, and likely to remain so until the US presidential elections in November. The fall in the dollar has effectively loosened monetary policy conditions further.
At the same time, the US has moved from a budget surplus to a large deficit within a short period of time. Judging from historic experience, this combination seems incompatible with low inflation in the long run.
As Tim Bond of Barclays Capital pointed out recently: "The objective of maintaining a positive inflation firebreak against deflation suggests that where policy errors are made they will be in the inflationary direction." This is about the right assessment. We are in no position to predict the return of inflation. But it is fair to say that the balance of risks has shifted.
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