Forgotten but not gone:
Inflation is not a problem, unless we forget about it
BARRY RILEY Financial Times; May 19, 2001

Inflation is the uninvited guest that reconciles the otherwise irreconcilable. Officially it is not a problem today, nor likely to be in the foreseeable future; at any rate, the US Federal Reserve is ignoring it.

This week the Fed cut interest rates by the fifth half-point instalment since January and stimulated a delayed celebration by Wall Street. The Dow Jones Average was pushed to a level 20 per cent above its March 22 low, and within 4 per cent of last year's all-time high.

However, US consumer price inflation is 3.3 per cent year-on-year, on the edge of causing concern. In the euro-zone inflation is 2.9 per cent, well above the European Central Bank's rate of 2 per cent, although that did not prevent the ECB last week from reluctantly joining in the global round of interest rate cuts. The UK is at 2 per cent, and the Bank of England is happy, mapping out in this week's inflation report a two-year projection which, as usual, lands exactly on its target rate of 2.5 per cent.

In Japan, though, inflation is slightly negative, which is distinctly uncomfortable in a modern economy. The uninvited guest, instead of reconciling an excessive demand for goods and services with an inadequate supply, by inflating prices, is reflecting the opposite. This is dangerous, because whereas rising prices stimulate spending, falling prices encourage consumers to wait and see. This is how recession turns to slump.

Hence suggestions by some economists that a red carpet should be rolled out and inflation invited into the Japanese economy through the explosive creation of liquidity. A tumble in the external value of the yen would stimulate exports and rising internal prices would encourage demand; but there would be angry responses from pensioners internally and industrial competitors externally.

Japan is exceptional. My own experience of the inflationary threat is that it sneaks up on us. We can beat it if we concentrate. But if our attention wanders to some other worthy objective, it can erupt again.

Globally inflation is fairly low - by the standards of the past 30 years, anyway, though not of the decades before that. Raw materials (oil apart) have been in plentiful supply, and there has been a rapid increase in the quantity (and improvement in the quality) of the manufactured goods traded around the globe. US inflation would probably be at least a percentage point higher if imported goods were not so cheap for people spending dollars.

One adverse result has been a squeeze on profits because the corporate sector cannot pass on higher labour costs in prices. But monetary regulators such as the Fed have realised that a tightening labour market does not present the same inflationary risks that it used to when economies were more closed.

But there have been peculiar sectoral shifts in inflation. In the UK, over the past year, inflation for leisure goods has been minus2.5 per cent whereas leisure services inflation has been plus 6.1 per cent: that is the difference between buying a TV set and going out to the cinema.

Until very recently the increasing fear of an economic slowdown, even a recession, has tended to calm inflationary worries. But monetary policies have been loosened around the world, with results that can now be seen clearly in the securities markets. Liquidity has rebounded: this week the London consultancy CrossBorder Capital issued a special alert to clients pointing out that a sudden recovery in its proprietary global liquidity index is bullish for equities.

This evidently reflects private sector cash flows rather than central bank loosening: money is bursting out. But the central banks would be more cautious, behaving more like the ECB rather than the Fed, if they were not so relaxed about inflation. This raises, however, the question of what will happen if the recession never arrives, or is steeply V-shaped and short.

The greatest concentration of gloomy experts worrying about this is to be found in the bond markets. Bond investors are people from whom inflation steals wealth to cross-subsidise the borrowers and spenders. Until early this year they rubbed their hands with delight at the prospect of a global economic slowdown: the prospective inflation rate implied by the gap between fixed and inflation-protected US Treasury bond yields dipped to 1.3 per cent.

Recent rate-slashing by the Fed has wiped the smiles off their faces. Within a few months the inflation implied by market yields has soared to 2.5 per cent. And in just two months the yield on the US Treasury's 30-year bond has jumped by two-thirds of a percentage point.

Certainly this has been a peculiar economic slowdown to understand. Most past recessions have been triggered by sharp interest rate rises imposed by central banks in the face of overheating and its consequences for inflation (up) and exchange rates (down). In this case a sudden bursting of the technology sector bubble has wreaked havoc in parts of the global economy, especially the US.

But most consumers appear scarcely to have noticed: UK retail spending was very strong in April. So the interest rate cuts required to rescue the tech wrecks may blow up bubbles elsewhere, notably in the housing market.

Will interest rate cuts solve a problem rooted in the corporate sector? The danger is that the Americans will apply a Japanese-type solution, cutting rates to very low levels, but the US economy proves still inflation-prone, while the trade deficit remains wide (it hit Dollars 31.2bn in March) and the dollar could yet prove vulnerable.

True, inflation pessimists in recent years have been forced to eat humble pie. The economic linkages in the late 1990s turned out to be very different to those of the 1970s. But inflation has not gone away.

Which brings me to the threat of the W-shaped recession. Too quick, and narrowly-based, a slowdown would leave underlying inflationary forces intact. Normally a final flourish of inflation at the tail-end of an economic boom can be expected as cost inflation feeds through and productivity gains are forfeited when output declines and capacity cannot be used efficiently.

But the recession itself will, according to the normal pattern, soon suppress inflation. This time, however, judging by the continuing strength of consumer spending, the inflationary tail may wag more strongly.

The danger is that if inflation accelerates further there will be little political resistance. In Japan it may be welcomed with open arms.