Global Agenda: From deflation to inflation

The term “strongly vigilant” triggers alarm bells, flashing lights and any other warning apparatus professional central-bank watchers may have.

On Thursday, at the regular press conference held directly following the fortnightly monetary-policy meeting of the European Central Bank, ECB President Jean-Claude Trichet said the bank would be “strongly vigilant” on the subject of inflation. For the hundreds (if not thousands) of professional central-bank watchers employed by financial institutions in Europe and around the world to track every utterance of every member of these institutions, this was a phrase that triggered alarm bells, flashing lights and any other warning apparatus they may have.
That’s because, in ECB-speak, being “strongly vigilant” means “we are now sufficiently concerned about inflationary pressure that we intend to raise interest rates very soon, most likely next month.”
The last use of the phrase is etched into every European economist’s memory, because it came in mid-2008 and presaged a raise in interest rates by the ECB the following month – in the face of a rapidly worsening global financial crisis. A few months later, after Lehman Brothers collapsed and liquidity in global markets dried up, threatening a collapse of the banking system, the ECB, along with all other major central banks, was forced to slash interest rates to unprecedented low levels and pour huge amounts of money into the markets to provide the liquidity so badly needed.
Given that background, and the ECB’s well-deserved reputation for “monetary hawkishness” – another jargon term, meaning that it is hypersensitive to inflation – it’s not surprising that other central banks view things differently.
Thus, for example, Bank of England Governor Mervyn King said in a speech Monday that he believed it would be wrong to raise interest rates now, because the inflationary pressures currently being felt around the world would prove transient. King prefers to “look through” these developments and focus on the medium-term outlook.
During two days of testimony to Congress on Tuesday and Wednesday, Federal Reserve Chairman Ben Bernanke adopted a similar line to King’s. He felt the current wave of price increases in food, energy and other natural resources would prove temporary and would not feed into a general rise in inflation in the United States.
Bernanke did note, however, that deflation fears have largely disappeared. In its own way, this statement is not less dramatic than that of Trichet. After all, in the face of the dramatic price rises in oil, grains and other commodities in recent weeks and months, it is difficult to recall that only a year ago it was the deflation fears to which Bernanke related that were of paramount concern to central bankers – and, for that matter, most other players in the global economy.
Indeed, the need to prevent the American economy from slipping into deflation – which is generally considered a more severe economic ailment even than inflation – was the primary reason cited by Bernanke for restarting the policy whereby the Fed purchases long-term US Treasury bonds in the open market. The Fed is now in the middle of an eight-month program to buy $600 billion worth of these bonds, as well as using the money arising from interest and redemptions on its existing bond holdings to make further purchases.
That the world is now focused on dealing with inflationary pressures, rather than deflationary ones, could be considered an achievement of Bernanke’s super-loose monetary policy, commonly called “QE2” (second round of quantitative easing). However, Bernanke does not take that credit. On the contrary, he and most of his colleagues claim that what is happening in commodity prices has nothing to do with monetary policy; rather, it is the result of global warming, geopolitical developments in the Middle East and other noneconomic factors.
On the other hand, many commentators in America and around the world – not those employed by the government or financial institutions, of course, but many of those of independent mind and employment – believe that Bernanke’s policy really is the major cause of the price inflation now making itself felt.
This latter view is not unaware of the impact of droughts, flooding and the like on grain prices, or of the civil war under way in Libya on oil prices. However, the magnitude of the price rises that have occurred reflect the huge amount of liquidity unleashed on the global economy – by central bankers generally and by Bernanke most of all.
This money has little productive use, given that demand in the developed world is still weak, and there is excess capacity in most sectors. It therefore finds its way mainly to the financial markets, which explains the buoyancy they have shown. But it also flows to commodity markets, where shortages caused by drought, or whatever, are forcing prices up.
The large amount of money hitting these relatively narrow markets has an outsize impact, generating massive price rises in many of them. As these price rises move through the supply chain, they force up prices of more and more goods, eventually showing up in inflation at the consumer level.
At that point, central banks have to refocus on inflation as their main target. In the rapidly growing developing economies – such as China, Brazil and, to a lesser extent, Israel – that point has long been reached. In Europe it seems to have been reached this week, but not yet in the US and UK.