With inflation numbers reaching multi-year highs globally and growth slowing, the symposium on globalization, inflation and monetary policy held by the Bank of France in Paris in early March was well-timed.
While the impact of the growing integration of markets on prices was thoroughly debated, it was the discussion on the dilemmas faced by central bankers in the current situation that revealed just how much of a mess the world is in today and how little our understanding is.
Illustration: Malay Karmakar / Mint
As William White of the Bank of International Settlements said, “At the worst, the implication might be that we may for a considerable period live in a fundamentally uncertain world, where probabilities are effectively impossible to calculate, rather than a world that is simply risky. At best, we have to recognize that the forecasting business is no longer business as usual.” At one level, the sentences are full of ambiguity— note the use of the words ‘may’ and ‘might’ but despite this, there is a precision that’s glaring at us, made clear by Martin Wolf of the Financial Times, who made no bones about the truth: “I no longer know what I used to think I knew. But I also do not know what I think now.”
To begin with, the jury is still out, not just on the root causes behind low inflation of the past two decades, but also on the present financial crisis. William White’s paper describes the ‘Great Moderation’ in inflation and neatly puts together the various hypotheses that have been offered to explain the coexistence of low inflation, low real interest rates and rapid growth —more effective monetary policy, increased domestic deregulation and more competition, increased globalization for both products and labour and a global savings glut. He does not address the policy response to inflation but from his model, which combines all these factors, two trends emerge—inflationary pressures are back again and the crisis in the advanced financial markets compounds the problems for the world.
The theories behind the turmoil are summarized in Wolf’s paper. He likens these to the story of the elephant and the blind men—explanations vary from a defective financial system due to “greedy, immoral, solely self-interested and self-delusional decisions made throughout the 2000s, and earlier, by very real human beings at the very top of the financial food chain” to ineffective regulation by central banks, easy monetary policy and global macroeconomic disorder with massive flows of capital into the US.
His conclusion is that the crisis is a wake-up call; we need more regulation not just of the micro and macro prudential variety that has been in place in the past, but also of incentives, in particular the structure of pay within businesses. Monetary policy should also pay attention to asset prices, he says; conventional wisdom in the Federal Reserve of allowing booms and cleaning up after the bust is not a desirable policy. Incidentally, the Reserve Bank of India’s (RBI) concern about asset prices, often regarded as quaint, just might be back in fashion now.
A much clearer articulation on expected inflationary pressures comes from Martin Redrado, governor of the Central Bank of Argentina, who is spot on when he says that the rising inflation is to a large extent due to the convergence of consumption levels—the developing countries are catching up in consumption patterns and change in dietary habits. His hypothesis is that we are approaching a true law of one price—developed countries are converging top-down and developing countries are moving bottom-up.
Redrado also lays emphasis on climate change reducing global grain output and the impact of high crude prices in diverting grain for biofuel production that has triggered off the rising prices in corn, soya, etc. As a result, while he expects a slowdown in growth to moderate the price rise in commodities, agricultural price rises are not expected to let up.
Food contributes a significant portion of consumer budgets in emerging economies and this will show up in forthcoming wage revisions, putting more pressure on prices. He also notes that the present financial institutional insolvency has a strong inflationary bias. With government-funded rescue of Bear Sterns and Northern Rock, this factor cannot be ignored; according to calculations by Nouriel Roubini, this can cost American taxpayers up to 20% of the US GDP. Another pressure comes from the potential insolvency lurking in the unfunded liabilities of the social security net in these countries, giving more credence to the hypothesis that the days of the Great Moderation are over.
Redrado’s paper has interesting policy implications as it puts a spotlight on the social and political tensions that will arise as countries are forced into a period of lower growth and higher inflation. In fact, distributional considerations do underlie the conservative approach followed in India; as RBI governor Y.V. Reddy said in his speech at the symposium —the poor reap the fruits of high growth with a time lag, while price rises affect them instantly. Further, when a financial crisis disrupts economic activity, the burden on the poor increases as there is no social security net. Consequently, RBI gives considerable weight to maintaining price and financial stability.
Amid all the uncertainty in the air, some conclusions do stand out clearly—on the inflation front, food prices will remain on the rise; on the finance front, there will be increased interaction between the government and the financial sector; and on the policy front, the ‘one size fits all’ rule does not apply in practice—each country will follow the policy response it considers best suited for its economy and society.
Sumita Kale is chief economist, Indicus Analytics. Comments are welcome at firstname.lastname@example.org