Download Inflation-Phobia Might Cause Stagflation “Central banks could revive

Inflation-Phobia Might Cause Stagflation
“Central banks could revive the stagflationary threat”
By Alfredo Coutino, Senior Economist, Latin America
Moody’s Economy.com. West Chester, PA, USA.
September 4, 2008.
•
Global inflation is mostly caused by external factors.
•
Monetary policy is generally ineffective against an inflation
caused by supply shocks as in the case of international prices.
•
Inflation panic has generated a global wave of monetary
restrictions, which will not contain inflation but will rather hurt
growth.
•
The main consequence could be a stagflation mostly induced by
central banks’ inflation-phobia.
The world economy could be soon threatened by a ghost, but this time
will not be the ghost of communism but rather the one of “stagflation”.
The global wave of inflation panic seems to be contaminating most of
central banks around the world, which have reacted showing an
“inflatiophobic” attitude. A more generalized monetary reaction, in
some cases “unjustified”, could certainly revive the stagflation ghost.
In Latin America, main central banks have already shown their
inflation phobia.
Monetary reaction to inflation panic
Central banks around the world have been reacting aggressively
against inflation and without caring about the real roots of inflation.
Despite authorities’ recognition of an inflation mostly caused by
international prices of energy and food, they have started a wave of
monetary restrictions. However, given the external root, on which
monetary policy proves to be ineffective, the global monetary
management gives the impression that central banks are basically
responding to an inflation panic rather than to the real causes.
Indeed, monetary policy is less effective to fight an inflation caused by
supply shocks; in fact, it is ineffective when the shock comes from
abroad. A general principle behind a consistent monetary management
says that monetary policy should be activated when inflation is caused
by demand factors, but not by supply shocks. Only in the few
exceptions when supply shocks are more permanent than transitory
and threaten with the development of a contamination process to
other prices, then monetary interventions are justified.
The reasoning is simple, supply shocks –such as in the case of
international prices of energy and food or bad weather causing
shortages of agricultural products– only generate temporary ups and
downs in the rate of inflation, but they do not produce a continuing
inflation for a sustained period of time. In other words, they only
produce changes in relative prices but not a sustained increase in all
prices.
Commodity Prices
Index, Dec 2002=100
500
Source: IMF
Total
Food
Fuel
450
400
350
300
250
200
150
100
J03
J04
J05
J06
J07
J08 J
A global wave
Even though central banks have recognized that inflation is mostly an
imported phenomenon, that there is no significant evidence of price
contamination, and that medium-term expectations remain well
anchored, they have overreacted and aggressively restricted monetary
conditions beyond neutrality. This way, central banks in Latin America,
Asia, Europe and Africa have not only raised interest rates but also
threatened with making monetary conditions even more restrictive.
Even in the U.S., where monetary conditions moved in the opposite
direction, the relaxation cycle has ended. The Fed has also recognized
that high commodity prices, particularly prices of energy and food,
continue to be the main risk for price stability. Since the Fed is
assigning a higher weight to inflation, the door is open to the
possibility of a new tightening cycle in the near future.
The Fed’s willingness to act in order to promote sustainable growth
with price stability leaves the door open to start using the monetary
margin available to move the reference rate up and closer to its
neutral level. In this case, however, the rate hikes would be justified
since monetary conditions are clearly expansionary in the U.S.
In Latin America
Meanwhile, Latin American central banks have started a wave of
monetary restrictions, thus widening the yield gaps and imposing
higher restrictions to local economies that are still trying to decouple
from the recessionary cycle in the U.S. Hence, central banks of Brazil,
Chile, Colombia, Mexico and Peru seem to have contaminated from the
global inflationary panic and have shown already their “inflatiophobic”
attitude through a generalized interest rate hikes. Even though they
also recognize that inflation is mostly an imported event, monetary
conditions have been tightened under the argument of trying to avoid
the deterioration of expectations.
However, there are particular cases in which monetary actions are
justified in the region. Even though all inflation processes have been
affected by international prices, there are few countries where inflation
contains an important component of demand pressures. For example
Chile, Colombia and Peru –whose economies have been running at a
speed faster than its potential in the past few years– have generated
an excess of domestic demand that has been accommodated in higher
inflation and more imports. In these countries, monetary conditions
were moved from expansionary to more neutral (Chile and Peru) or
even to a more restrictive stance (Colombia). On the other side,
countries like Brazil and Mexico that explain two thirds of the region’s
GDP, and where there is no evidence of an excess demand, monetary
policy has turned more restrictive and basically responding to the
market’s inflation fears.
r
10.0
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
LatAm Monetary Policy Stance
Annual rates, %
Restrictive
Zone
BRA
Perfect neutrality
COL
MEX
CHI
PER
Expansive
Zone
Source: Moody’s Economy.com
1.0
2.0
3.0
4.0
5.0
6.0
7.0 GDP
An unnecessary result
In the end, if the wave of monetary restriction keeps gaining
supporters around the world and even intensifies, then the liquidity
constraint combined with higher financial costs will necessarily impose
a toll on economic growth. The domestic demand would contract
unnecessarily by effect of the monetary restriction, consequently
generating a deeper slowdown in the global economy. Even worse,
inflation will continue to stay high and relatively immune to monetary
restrictions because price increases do not depend on demand
pressures but on international factors. Thus, nothing guarantees that a
global slowdown will induce a dramatic fall in prices of energy and food
because they are not caused by an excess demand but rather they are
the result of capacity restraints in the main producers.
In this scenario, inflation will remain high even under stricter monetary
conditions, but global growth will be hurt unnecessarily. In this sense,
the probability of a scenario of “global stagflation” increases. However,
the threat of stagflation over the world economy will not be the
consequence of the U.S. recession but rather an event induced by
central banks’ inflation-phobia.
This commentary is produced by Moody's Economy.com, Inc. (MEDC), a subsidiary
of Moody's Corporation (MCO) engaged in economic research and analysis. MEDC's
commentary is independent and does not reflect the opinions of Moody's Investors
Service, Inc., the credit ratings agency which is also a subsidiary of MCO.
Moody's Economy.com (MEDC) is a subsidiary of Moody's Corporation, and is
headquartered in West Chester, Pennsylvania. MEDC is a leading independent
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