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|  | Riccardo Sorrentino, born in 1964, has worked at Il Sole-24 Ore since 1992. In the past years, he has attended several international summits, including the Palermo G-7 of Finance Ministers and Central Bankers in 2001, and the WTO conferences of Cancun (2003) and Hong Kong (2005) and he has covered several G-10 central bank meetings at the BIS and ECB press conferences. As a special correspondent, he has been in The Netherlands; in the US; in Iceland, in Hungary, in Singapore, in Indonesia, in India, in Norway, in Thailand, in Pakistan, in Armenia. In the 2003-2004 winter and in the 2006 summer, he worked at Il Sole 24 Ore's North American bureau in New York. |
| | riccardo.sorrentino@ilsole24ore.com |
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| The inflation ghost is back |
| November 9, 2007 |
The ghost is back. Frightening as always. Everywhere inflation is growing, pushed by energy and food prices, the most difficult to handle by monetary policy tools. It is a problem, a big problem that is occurring at the wrong time. Oil and food prices are rising while in the global economy growth rates are slowing: the housing crisis from United States is gradually spreading through financial markets everywhere.
THE DILEMMA
This situation makes even more difficult the Central bankers' task. Fostering growth and stabilizing prices are often conflicting targets with different time horizons. To support growth today could put at risk the anchoring of inflation expectations and could push prices up in the future. To handle inflation today, and particularly oil and food inflation, could slow down an already weak real economy.
A DIFFICULT CHOICE
The Fed is facing a difficult challenge, but it has had few doubts about what to do so far, even if it has now some risks to bear. Central bankers in Washington cut policy interest rates by 50 basis points in summer, then by other 25 basis points - with one vote against - on October 31st. The Fed is sending now a clear message: at the moment, unless a new alarming situation arises, the easing is over. The October statement wrote: "The Committee judges that, after this [interest rates cut] the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth". A clear indication: from now on the Fed will be ready even to raise interest rates if the inflation turns out to be the main risk.
PRICES RISKS
The Fed seems to stress the risks on growth, worrying financial markets. But Central Bankers, in Washington are instead stressing the risks on growth and the risks on inflation. On November 5th, Frederic Mishkin, alter ego of Ben Bernanke just like the vice chairman Donald Kohn, made a very interesting speech, more meaningful than the chairman testimony before the Joint Economic Committee of the U.S. Congress, three days later. Mishkin told the reasons of his choice: "In voting to ease policy, I carefully considered the effect of that decision on our other objective--price stability. I reasoned that the anticipated softening of economic growth and perhaps the emergence of some slack in the labor market might reduce those pressures, and I judged that a cut of 25 basis points in the target federal funds rate would not materially alter that modal outlook. However, I recognized the risk that, even if readings on core inflation have improved modestly this year, recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. Consequently, in considering appropriate future adjustments to policy, I will monitor inflation developments carefully".
A PRUDENTIAL STEP
The October policy easing was not strictly necessary. It has been a prudential step. "Going into the meeting - said Mishkin - I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth. I was mindful, in particular, of the risk that still-fragile financial markets could be particularly exposed to potential adverse news on the housing situation, or on the macroeconomy more generally, and that renewed strains in financial markets could feed back adversely on economic performance. My vote to ease policy at the meeting was motivated by my wish to reduce those risks. The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed".
THE ECB CODE
The job of the European central bank is even more difficult. The subprime crisis erupted while the tightening cycle was not over. Still the Bank code - its rhetoric - allows distinguishing between functions and objectives: first the price stability, then the economic growth. During the press conference, on November 8th, the president Jean Claude Trichet lived up to his reputation: he almost ignored the downside risks on growth, explained that the Ecb needs more data to move the policy rate, and stressed that the real risk, maybe the only risk, is that of a disanchoring of inflation expectations, even more dangerous that the inflation itself; and that it is mandatory to act timely against that possibility. "We will do - he said - what is necessary to continue to solidly anchor inflation expectations. We are looking very, very carefully at all the surveys, all the information that we extract from financial markets and we see reasons to reaffirm solemnly that we will not let any disanchoring of inflation expectations and the delivery of price stability over time are totally depending, in a period when we have a hump in headline inflation, on the absence of the second round effect".
THE OLD BOGEYMAN
The weak spot are emerging markets. They have so far exported disinflation. Many economists warn about the risk to growth raised by the slowing US economy, but the real danger, for the global economy, is elsewhere. «There is another fear to contend with - explained Philip Pool at Hsbc in a report - one that is inside the Emerging market house, or at least some of its rooms. Inflation, the old bogeyman, has returned from the grave to haunt policy makers. The evidence is widespread: BRICs [Brazil, Russia, India, China], Argentina, Mexico, South Africa, Vietnam, much of Central Europe, the Gulf States and others are all feeling the impact. This situation is the result of a combination of evils: surging food price inflation, incomplete sterilisation of domestic liquidity arising from currency intervention and tightening capacity constraints"
THE MONSTER OF DEFLATION
A question arises. If developed economies - US, above all - are slowing down, and emerging market, for domestic pressures, begin to export inflation, there will be a risk of stagflation. It is a more haunting ghost than inflation. "Some investors - Stephen Jen and Luca Bindelli at Morgan Stanley explained in a report - hold the view that the US could experience both recession and inflation. First, it is argued that global economic decoupling could produce strong inflationary pressures outside the US to prevent US inflation from trending lower with lower growth. Second, some investors believe that global commodity prices will continue to experience a structural up-trend, almost regardless of the state of the global economy. This commodity price inflation will, so the argument goes, keep US headline inflation high, despite a falling core inflation". In October, Jen and Bindelli disagreed with those economists. Now another economist at Morgan Stanley, Joachim Fels, warns: "While I agree that recession is a serious risk, I think what lies ahead in the next several quarters is more likely to be a period of stagflation - slow or no growth combined with rising inflation - in the advanced economies. The case for stagflation rather than recession and disinflation rests on still-strong growth and rising inflationary pressures in emerging market economies. Strong demand from emerging markets will support export growth in the advanced economies. At the same time I expect the global inflationary pressures emanating from the emerging world to outweigh the disinflationary forces from slower domestic demand growth in the advanced economies". |
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