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Opinion: Inflation is a subtler threat than it appears

First published: Financial Times,19/05/2008

If the banking and housing crisis has not yet made you queasy about the economic outlook, concerns about rising inflation probably will. Or so it is asserted. Central banks issue frequent warnings; analysts refer to the rise of inflation as horrific or disturbing and in the blogosphere talk is of a new inflationary era.

The inflation risk is certainly not trivial, especially in emerging countries, but there are two major reasons why the new scares should not be taken at face value in advanced economies yet. Moreover, to the extent that food and energy prices are a problem, governments should respond soon for fear that central banks’ duty bound to contain inflation expectations end up making the financial crisis worse.

First, banking crises and rising inflation make for improbable bedfellows. As de-leveraging evolves, the risks to growth, employment and profits are much more likely to produce disinflation. Two processes have much further to go before the credit crisis stabilises: the re-capitalisation of lenders and the build-up of personal savings. Both processes are deflationary and tell us more about future inflation risks than today’s commodity prices, which are in large measure the legacy of the global boom that is fading into the past.

Second, inflation in western economies is akin to Sherlock Holmes’ curious incident of the dog in the night. Advised that the dog did nothing, Holmes said that that was the curious incident. In clothing, cars, communications, health (excluding the US), household goods and housing, price inflation is non-existent or weak. The problems are those goods and services directly affected by the surge in prices in energy, food and strategic metals. Thus, while headline inflation has risen to 3-4 per cent, core inflation has remained quite stable in the last two years, fluctuating around 2 per cent.Moreover, there are few signs of troublesome inflation in labour compensation. If there has been no marked acceleration in wages so far, there is little prospect of it emerging as unemployment rises. Further, US productivity growth has rebounded to a four-year high, producing unit labour cost growth of a mere 0.2 per cent in the first quarter. Productivity growth in the UK and the European Union, by contrast, slipped in the last few quarters: unit wage costs edged up 2.7 per cent in the UK, and 2 per cent in the eurozone. This European trend remains benign — and may reverse as job cuts pick up — but does merit attention.Food and energy inflation is a problem, especially for poorer citizens. Moreover, other sources of cost inflation that have not been seen in a long time have become evident, for example in steel and in technology components. These developments all carry the footprint of emerging markets, which either set or comprise the marginal determinant of many world prices.Rising inflation in emerging markets is serious for two reasons. First, it is more destabilising socially and dangerous politically. Secondly, it reflects a cocktail of loose monetary policies, economic overheating and rising unit wage costs. But for the proliferation of price controls and subsidies applied to food, fuel and housing, reported inflation would be much higher. Emerging markets will see more credit tightening in the coming year but this will not be effective until they allow their currencies to appreciate more significantly or revalue against the US dollar and euro.As western growth stagnates and emerging economiesÕ growth slips back, commodity demand and supply factors will realign to produce a meaningful fall in prices.Even so, for structural reasons, such declines may be short-lived. If we have not started to deal with the longer-term issues of resource constraints and global demand patterns by the time the economic upswing arrives in 2010 or so, we could have a more awkward inflation environment, aggravated in the west by the start of an age-related expansion in public spending and by higher wages reflecting ageing-related labour and skills shortages.This window of inflation relief should not be wasted. Governments should think ahead and encourage capital spending in energy. They must abandon the folly of bio-fuel subsidies, free agricultural trade and promote farming technologies. They need to embrace an agenda that recognises high food and energy prices are here to stay. Rather than allowing these to add to rising inflation expectations, they should help economies adjust to higher resource prices. If the response is weak, the curious, but not unexpected, incident will be that they did nothing.