Inflation has traditionally been seen either in terms of supply-demand imbalances, or as a monetary phenomenon, and largely in terms of consumer prices. According to Milton Friedman?s famous dictum, ?Inflation is always and everywhere a monetary phenomenon.? Globalisation is, however, changing the way inflation is viewed and transmitted. It is increasingly becoming an ?internationally tradable virtual commodity? over which governments and central banks have little control. A gap has also opened up between consumer, commodity and asset prices.
Current inflationary expectations need to be seen against the backdrop of the remarkable macroeconomic stability that has characterised the opening decade of the 21st century, combining record levels of output growth with low rates of inflation. According to IMF estimates, global output rose from an average of 3.2% per annum in 1989-98 to 4.4% in 1999-08, driven by a dramatic increase from 3.8% to 6.4% in emerging and developing economies.
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 epic, 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 heroic. This deflation occurred despite the Goldman Sachs broad commodity index jumping by 288% over the six years to February 2008. This has led to a major disconnect between consumer and commodity prices, reflected in an emerging gap between core and headline inflation in developed economies, and between WPI and CPI in India, where there is currently a 2% difference. This is because core inflation indices are relatively insulated against volatile commodity prices.
It is widely believed that increasing crossborder movement of goods and services has muted demand-supply imbalances, while productivity gains and the integration of huge labour markets in China and India exported price deflation over the past decade despite the huge demand generated by record growth. At the same time, huge OECD subsidies exported agricultural deflation.
On account of the disinflationary effect of globalisation on tradable goods and services, excess money supply mostly impacted non-tradable assets such as real estate, or partially tradable financial assets like stock prices. Thus, the US real Home Value index that fluctuated within a relatively narrow range of 90-120 over the last century from 1890 (=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 annually on average by 8% between 2002 and 2008. This pattern was replicated in developing economies such as China and India.
Globally, monetary policy, generally based on the widely accepted Taylor Rule, typically targets core inflation to stabilise output growth. The trend therefore was for central banks to follow loose monetary policy since core inflation was low. The lax monetary policy of central banks was, however, only the proximate reason for the surge in global liquidity that inflated asset bubbles, including the subprime crisis. Alan Greenspan, the erstwhile US Fed chairman, confessed to the Fed?s helplessness in influencing long-term interest rates that responded more to huge crossborder capital flows. The ultimate cause therefore lay in humungous crossborder financial flows deriving from huge current account surpluses of developing countries (Bernanke?s ?savings glut?), and financial innovation such as credit derivatives. These surpluses tended to be deflationary since they generated huge demand for dollars on account of emerging markets? unwillingness to let their currencies appreciate, thereby appreciating the currency in which international trade, including oil, was mostly priced.
The recent surge in commodity prices, particularly oil, would seem to indicate that supply side constraints have at last caught up with record levels of growth. Emerging markets now threaten to export inflation through their unquenchable demand for commodities, even as OECD countries export ?agflation? by diverting food grain for biofuels. The Economist commodity index has risen by 45%, and the food index by 70%, over the past year ending March 4, 2008. The falling dollar is also fuelling inflation.
But why commodity and oil prices continue to scale historic highs well after recessionary fears have crystallised is mystifying. While Asia?s contribution to global growth and trade has increased significantly in recent years, as has intra-Asia trade, the US share in Chinese exports has remained constant at just over 20% over the last decade. Since much of intra-Asian trade feeds this continuing global imbalance, the decoupling hypothesis seems weak, and stockmarkets certainly seem to think so. If that is indeed the case, commodities are hardly likely to provide a medium to long-term hedge against asset deflation in OECD countries and the dollar?s sharp slide. The proceeds of continuing global imbalances, now bolstered by a fresh surge in ?petrodollars? and ?commodollars?, would however need to be parked in assets somewhere?in America, Europe or emerging markets.
The dollar may well be the bellwether currency indicating which way the wind blows and how inflationary expectations crystallise.
?The writer is a civil servant. These are his personal views