There is apparently serious debate in the American economics community on whether the large amount of dollars sloshing around in the system will fuel inflation going forward. The venerable and loquacious Paul Krugman is on one side and argues that in the current environment the textbook relationship between excess money and inflation does not quite hold. “These aren’t ordinary times,” he writes on his blog, “banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really ‘printing money’ after all...it would be a big mistake if the Fed lets fear of inflation distract it from the urgent task of heading off a financial meltdown.”
The US Federal Reserve Board seems to be squarely in the Krugman camp. Fed Chairman Bernanke in a testimony to the Congress last week underplayed the fears of inflation. “We anticipate that inflation will remain low,” he said, adding “the slack in resource utilisation remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued.” Incidentally, the American central bank has, in the past few months, added $1.45 trillion of new money through its quantitative easing programme (buying back government and other bonds) and plans to add more as long-term yields head northward pulling things like mortgage lending rates up with them. There are others, however, who are not as sanguine as Bernanke. Inflation expectations embedded in the treasury inflation-protected securities (TIPS) market have been climbing steadily. In May 2009 itself the implicit ‘breakeven’ inflation rate on 10-year TIPS has moved up by about 70 basis points.
Krugman does have a point. With soaring unemployment that is to decline in a hurry, wage pressures are unlikely to emerge for a while. Thus the spiral of rising wages and prices that usually goes with high inflation is unlikely to emerge as a risk in the foreseeable future. Krugman’s logic appeals to basic intuition — high inflation is a corollary of high growth; it is unlikely to come in a severe recession. The policy implication — the US central bank should continue to pump money until it sees more definitive signs of a pick-up in the real economy.
However, one surely cannot ignore the impact of high liquidity on commodity prices. Take the case of oil. From their February lows, crude prices have moved up by over 50 per cent. Much of the increase in prices came in May and coincided with the rally in stock prices. This is actually more than sheer coincidence. Much of the recent rise reflects the so-called ‘financialisation’ of commodity markets, a rather succinct term that describes the fact that commodities have become an asset like stocks. This means their prices respond to the same factors that drive sharp rallies in stocks. Thus the recent rally in both oil and stock markets played on the heady mix of rising risk appetite and high liquidity.
Financialisation does not mean that markets disregard fundamentals like the balance of demand and supply. Unfortunately, for most commodities, supply has been under strain and this is likely to continue as long as large investments go into augmenting production wherever possible. These investments are unlikely to happen in a hurry and supply is likely to fall short of demand. The upshot is that for most commodities there is a fundamental tendency for prices to rise. The fact that they tend to be traded as assets exaggerates this tendency and causes prices to flare up more than the simple arithmetic of demand and supply would suggest.
Thus the prospect of oil prices returning to $100 a barrel seems real. Could it derail the nascent recovery in the global economy that seems under way? Some (including Krugman perhaps) would argue that central banks should focus entirely on ‘core’ inflation and not try and fight price pressures in commodities by tightening money. A spurt in oil or other commodities would tend to be ephemeral and would not ‘embed’ itself into the economy unless real demand conditions picked up.
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That, for any central bank, is a difficult call to take. It is certainly not one that the bond markets would buy into. They would tend to take cues more from headline inflation numbers rather than core inflation trends. Thus rising commodity price inflation is likely to translate into higher bond yields and higher interest rates in general. For a net importer of commodities like India, the rise in oil prices could also push up the current account deficit. Thus the rise in capital inflows could get gobbled up by a rising commodity import bill.
Both rising interest rates and a widening current account could scupper growth. Thus the global economy and India run the risk of ‘stagflation’ before they even begin to show decisive signs of recovery. This is exactly the risk that threatened the globe in 2008 when high oil prices and inflation seemed to accompany a severe economic slowdown. I would argue that hiking interest rates or tightening money is a textbook solution to an unusual problem — one that’s likely to create more problems than solve them. The only way out of this is for governments to get together and regulate the flow of ‘speculative’ investments in commodity markets (something akin to banning futures in commodities if you want a local example). This might seem terribly anti-market and all that, but surely, the financial crisis has taught us that the market is not always right.
The author is chief economist, HDFC Bank. The views here are personal