Monday, 14 February 2011

The New Inflation

Long time ago, back at university, I tried to make sense of the concept of “core inflation”. Consumer price inflation minus what was known as the volatile components, food and energy. I sort of understood it, but never really came to terms with it.

It is correct that by keeping the notoriously volatile elements out of the equation, one arrives at a notion of inflation that can be used in analysis of such important questions as the deflationary effects of the output gap. We have all been conditioned to believe that this is the most important way to think of inflation.

But still we have a slight problem. We, the consumers, let our economic decisions rule by the inflation as we see it in the shops or in the street. No matter how much the textbooks tell that the core inflation is the most important to watch, shop owners who increase their prices would be unwilling to let me pay only part of the increase just because the “core inflation” was lower than the headline inflation. The supermarket bill goes up and it will have to be paid, no matter where the increases come from.

So while core inflation is an element that makes sense to economists, headline inflation makes sense to the rest of the population. Including possibly even some of those working in the financial sector.

Right now we are at a point where this distinction between core inflation and non-core inflation is as important as ever. Looking at core inflation in most of the OECD area tells us that inflation is not a problem. Looking at the output gaps gives the same conclusion.

But inflation is on the rise. Food and energy prices are pulling up the headline inflation to a point where it is getting uncomfortable. A combination of financial market speculation and adverse production circumstances are working their magic.

Add a point we have made several times in 2010. Federal Reserve’s re-acceleration of the QE programme in September was bound to create asset inflation and nowhere more clearly in the comparatively small markets for commodities and energy.

The increase in the volatile inflation components have been one of the elements in destabilising regimes everywhere from Venezuela to North Africa. Following a very bad harvest, the Chinese Government is seriously concerned about food inflation – to the point where initiatives have been implemented locally to curb the inflation.

It all adds to an uneasy feeling: are we heading towards a period of inflation, pulled by exactly the elements that according to economists are irrelevant for understanding the “real” inflation? Can policymakers be forced to step on the brakes early in order to avoid inflation expectations taking hold, even if core inflation remains benign? Or, will the financial markets – in particular the bond markets – begin to take discount this inflation, no matter if bank economists tell that it is irrelevant.

The answer to this question is more important than the financial press seems to have understood. If the markets begin to fear inflation, bond yields will push upwards and threaten to put the brakes on the recovery at a time when policymakers consider using the increasingly self-sustained recovery to begin cutting the budget deficits. The combination could prove very negative for the economic growth in a global economy where consumers in the western world still need to consolidate their balance sheets.

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