Samuel Brittan no FT.com

When inflation comes from abroad

By Samuel Brittan

Published: March 27 2008 19:02 | Last updated: March 27 2008 19:02

The discussion of world credit problems has concentrated too much on the trees and not enough on the wood. We hear a lot about which financial institutions should be bailed out by central banks and on what terms; which financial instruments are most to blame and whether they can be better regulated in the future. Of course these are important questions, however embarrassing they are to those who have preached nonintervention and competition.Yet in all this detail it is easy to lose the point of the exercise, which is perhaps too simple for the technocratic mind. It is to ensure a growth of nominal spending – that is spending in cash terms – rapid enough to support sustainable growth but not so rapid that it generates unacceptably high inflation. Whether this is brought about by conventional central bank interest rate policy, the reanimation of moribund credit and capital markets, tax cuts or sensible government spending is secondary.

But even if we stick to general principles, a difficulty presents itself. This is that, in spite of the recession threat, inflation has been driven up, not by the old-fashioned wage-price spiral, the threat of which still terrifies policymakers, but by rising commodity prices – energy, food and industrial metals. The S&P GSCI commodity index has, it is true, fallen since mid-March. But it is far too early to conclude from this that we have merely seen the pricking of a speculative bubble. Spot industrial metals are still twice as high as three years ago, as are agricultural and energy prices.

The near-14 per cent depreciation of the dollar accounts for some of the rise, because these indices are expressed in dollar terms. But it is clearly not the main factor. Until recently, high commodity prices were to some extent offset by the switch of industrial demand to the products of low-cost emerging countries, above all China. But relief from that source may be ending as China struggles with its own inflation problems.

We should not exaggerate. The UK has an inflation target of 2 per cent and the eurozone one of “close to 2 per cent” on the official “harmonised index of consumer prices”. Both of these areas have seen inflation only two or three decimal points above 2 per cent in the past few years. Both the European Central Bank and the Bank of England expect at least a temporary bulge in coming months, and the UK inflation rate reached 2.5 per cent this February.

The US is in a different category. It has no official inflation target and the actual rate has hovered between 3 and 4 per cent in the past few years. Even so, the Federal Reserve has no intention of allowing this rate to escalate.

If the recent commodity price shake-out proves the harbinger of a medium-term downturn in the cost of food, energy and materials, then the central banks’ dilemma largely disappears. For then they need not hesitate to do whatever is required to support a sustainable growth of nominal demand, usually reckoned to be about 5 per cent a year.

But if commodity and energy prices resume their climb, we are back with the dilemma with which we started. While past recessions have been associated with falling commodity prices, the current world slowdown coincides with an upward drift in material and energy prices as countries such as China and India industrialise.

It is one thing for central banks to hold price increases generated in their own countries or regions to 2 per cent. It is quite another to compress them to offset potentially large price increases emanating from outside their area. The Bank of England estimates that imports account for a third of UK business input costs, but not all are fuel and materials.

What all this is leading up to is a suggestion that the emphasis in counter-inflationary policy should shift towards domestically generated inflation. There are of course huge problems in calculating this. To begin with, import price increases, to the extent that they reflect a depreciating exchange rate, cannot be excluded. One of the main ways an inflationary domestic policy makes itself felt is through the exchange rate.

A more difficult problem is how to treat products whose price is determined in a clearly defined international market. The Bank of England emphasises the rise in wholesale gas prices as a contributor to the bulge in consumer price index inflation. But is this entirely a domestic matter? Whatever is said to the contrary, it is the rise in world energy prices that gave the UK gas providers their opportunity.

An index of domestically generated inflation is not something that can be worked out quickly on the back of an envelope. But, as with other statistical conundrums, a better-than-nothing estimate should eventually be possible. I am certainly not suggesting yet another early change in the definition of the inflation target to confuse citizens and voters. For the time being, all that is required is some emphasis on the domestic versus external elements in inflation in, for instance, the monthly press conference of the ECB or the letters the governor of the Bank of England is required to write to the chancellor when inflation strays by more than one percentage point from target. Then we can see.

www.samuelbrittan.co.uk

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