Inflation Reality Check

By Kenneth Rogoff
Project Syndicate

CAMBRIDGE ― As inflation continues to soar everywhere, maybe the world's central bankers need a jolt to awaken them from complacency.

How about holding one of their bi-monthly meetings in hyperinflationary Zimbabwe? It might not be comfortable, but it would be educational.

According to Zimbabwe's official statistical agency, inflation topped 66,000 percent in 2007, which looks more like Weimar Germany than modern-day Africa.

While no one is quite certain how the government managed to estimate prices, given that there is virtually nothing for sale in the shops, most indicators suggest that Zimbabwe does have a good shot at breaking world records for inflation.

Of course, curious as they might be, central bankers could decide that meeting in Harare would be too inconvenient and politically unpalatable.

Fortunately, there are lots of other nice ― albeit less spectacular ― inflation destinations. Inflation in Russia, Vietnam, Argentina, and Venezuela is solidly in double digits, to name just a few possibilities.

Indeed, except for deflation-ridden Japan, central bankers could meet just about anywhere and see high and rising inflation. Chinese authorities are so worried by their country's 7 percent inflation they are copying India and imposing price controls on food.

Even the United States had inflation at 4 percent last year, though the Federal Reserve is somehow convinced that most people won't notice.

Many central bankers and economists argue that today's rising global inflation is just a temporary aberration, driven by soaring prices for food, fuel, and other commodities. True, prices for many key commodities are up 25 percent to 50 percent since the start of the year.

But if central bankers think that today's inflation is simply the product of short-term resource scarcities as opposed to lax monetary policy, they are mistaken.

The fact is that around most of the world, inflation ― and eventually inflation expectations ― will keep climbing unless central banks start tightening their monetary policies.

The U.S. is now ground zero for global inflation. Faced with a vicious combination of collapsing housing prices and imploding credit markets, the Fed has been aggressively cutting interest rates to try to stave off a recession.

But even if the Fed does not admit it in its forecasts, the price of this ``insurance policy" will almost certainly be higher inflation down the road, and perhaps for several years.

America's inflation would be contained but for the fact that so many countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements.

As a result, whenever the Fed cuts interest rates, it puts pressure on the whole ``dollar bloc" to follow suit, lest their currencies appreciate as investors seek higher yields.

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ― perhaps as much as 60 percent ― of the global economy.

But, with most economies in the Middle East and Asia in much stronger shape than the U.S. and inflation already climbing sharply in most emerging-market countries, aggressive monetary stimulus is the last thing they need right now.

The European Central Bank is staying calm for the moment, but it, too, is probably holding back on interest-rate hikes partly out of fear of driving the euro, already at record levels, even higher.

And the ECB worries that if the U.S. recession proves contagious, it may have to turn around and start slashing rates anyway.

So what happens next? If the U.S. tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing.

Global commodity prices will collapse, and prices for many goods and services will stop rising so quickly as unemployment and excess capacity grow.

Of course, a U.S. recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the U.S. recession remains mild and global growth remains solid.

In that case, inflation could easily rise to 1980's (if not quite 1970's) levels throughout much of the world.

Until now, most investors have thought that they would rather risk high inflation for a couple of years than accept even a short and shallow recession.

But they too easily forget the costs of high inflation, and how difficult it is to squeeze it out of the system. Maybe they, too, should try holding a few conferences in Zimbabwe, and get a reality check of their own.

Kenneth Rogoff is professor of economics and public policy at Harvard University, and was formerly chief economist at the International Monetary Fund (IMF). For more stories, visit Project Syndicate (www.project-syndicate.org).

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