Inflation in a globalising world

Consumer price inflation in advanced economies fell from an average of 3.3% in 1989-98 to 1.7% in 1999-08. The decline in emerging and developing economies was dramatic, falling from an average of 50.3% to 6.2%. While Asia saw a drop from 9.7% to 3.1%, the decline in putatively hyperinflationary developing economies in the western hemisphere from 134.2% to 7% was truly epic. Not only does supply appear to have kept pace with the record expansion in output, but rapid and increasing globalisation, in particular the integration of huge labour markets in China and India, also resulted in price deflation across the globe in tradable goods and services over the past decade.

Sustained levels of high global growth, especially in China, has nevertheless resulted in supply side constraints on the supply of commodities, as a result of which commodity prices?particularly oil?are currently enjoying an unprecedented boom. The Economist commodity index shows an increase of 15% in commodity and 30% in food prices over the past year.

In the past, high oil prices fuelled inflation, but not so this time around. As a result, there is presently a major disconnect between consumer prices and commodity prices, which is reflected in an emerging gap between headline and core inflation in developed economies, and between WPI and CPI in India. This is because headline inflation indices are mostly insulated against volatile commodity prices. It is widely believed that major emerging economies, such as China and India, have absorbed most of the increase in oil prices in the fisc and through productivity increases.

Globally, monetary policy, generally based on the widely accepted Taylor Rule, typically targets headline inflation (WPI in India) to stabilise output growth. The recent trend, therefore, has been for central banks to follow a loose monetary policy since headline inflation has been low. Asset prices, on the other hand, have been unusually exuberant over this period of low inflation. Thus, the US real Home Value index that fluctuated within a relatively narrow range of 90-120 over the last century from 1890 (base 100) to 2000, except during the Great Depression, rose sharply over the last 4-5 years to touch 200 in 2006. The Dow Jones rose at an annual average 8% between 2002 and 2008. This pattern was replicated in developing economies such as China and India.

According to received wisdom, excess money supply fuels inflation. According to Milton Friedman?s famous dictum, ?Inflation is always and everywhere a monetary phenomenon.?

While the common sense meaning of inflation is consumer price inflation, there is nothing in monetarist logic to suggest that excess money supply can leave some kinds of inflation relatively unaffected while being mostly transmitted to particular classes. On account of the disinflationary effect of globalisation on tradable goods, excess money supply has mostly impacted non-tradable assets such as real estate or partially tradable financial assets like stock prices.

One of the reasons underlying this excessive liquidity was cross-border financial flows deriving from huge current account surpluses of developing countries (Bernanke?s ?savings glut?), and financial innovations such as credit derivatives that are widely believed to have inflated the subprime credit bubble. There were apparently no limits to this asset exuberance because they were not even on the radar of central banks that were targeting consumer prices. Yet, the changing nature of inflation in a globalising economy may well herald a change in the basket of goods and services used for price indices?and inflation?and arguably for monetary policy.

The author is a civil servant. These are his personal views