Surjit S Bhalla: ECB - Worst Central Bank?

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Imported inflation cannot be handled by domestic monetary policies, and nor can it be reduced by exchange rate appreciation.

Was it only yesterday that the Central Banks were congratulating themselves on having brought inflation down from a world median level of 7.9 per cent in 1990 to only 4.8 per cent in 2006? It was "" and the conclusion reached was that inflation targeting by the major central banks in the world was the instrument. This view has been challenged on the grounds that world inflation was most likely brought down by unprecedented and fast productivity growth in developing economies, led by China and India.

So what has happened now? That is worthy of investigation, and a lot of worthies are investigating! In today's article, I want to look at not what policymakers will do, but what they have done over the last two years. The following facts are well known. First, inflation is up (2008 March relative to 2006 March) in practically every country in the world. Second, it is not wage growth that is driving up inflation but rather supply-side inflation. Prices of metals and minerals, including petroleum, are up quite significantly, as are prices of agricultural goods.

Economists, and policymakers, differ on the appropriate policy response. There are the monetarists, e.g. the European Central Bank (ECB), who believe that inflation is a monetary phenomenon, at all times. Some of the domestic followers of the ECB have called for both a hike in interest rates and a hike in the cash reserve ratio (CRR). There are the exchange rate fundamentalists who argue that the way out of the inflation problem is for a currency to appreciate. Then there are others who believe that imported commodity inflation cannot be tackled by monetary or exchange rate measures. Not monetary because it is not money demand that is causing the price of imported wheat to go up; it most likely is a drought in Australia, one of the largest exporters of wheat. It is not monetary demand that causes corn prices to go up "" it most likely is the stupid (?) US policy of trying to get fuel out of corn, no matter what the price. Shades of alchemy. A third possible cause for worldwide commodity inflation is the large decline in the value of the dollar. But this has happened so many times in the last 30 years, and happened without a corresponding rise in commodity or world inflation, that the explanation should not be given much weight.

There is the appealing insight of the exchange rate fundamentalists. Their explanation is as follows. Imported inflation is not a monetary phenomenon, so it should not be tackled by monetary measures. But given that it is imported inflation, exchange rate appreciation can directly help by making the cost of imported goods cheaper. How much can it help? Assume the share of imported goods is 30 per cent, and that import inflation is 10 per cent. Without exchange rate change, this will cause domestic inflation to increase by 3 percentage points. If, however, the exchange rate is allowed to appreciate by 10 per cent, then this entire 3 percentage points of imported inflation can be wiped clean to zero.

Which of the above three policies have actually worked to reduce inflation is an empirical question. The table reports on inflation, and inflation and exchange rate change, for some 20-odd countries. The data are from The Economist, and report year on year inflation in March 2006 and March 2008. The final column reports the excess inflation that has occurred after incorporating the simple inflation reducing effects of exchange rate appreciation (as documented in the above example). Countries are ordered according to their failure in reducing inflation after accounting for currency appreciation.

Some, indeed several, surprises. The most successful country "" the US. With an exchange rate depreciation of 25 per cent, it achieved a 7 percentage point lower inflation rate. China is the third worst country "" excess inflation of 11.4 per cent. The country with the most monetarist concern about inflation, Germany (via the Bundesbank before and now the ECB), has the worst inflation fighting record among developed economies (excepting Sweden). Given the large 27 per cent appreciation in the euro, inflation in Germany should have been -6.5 per cent instead of 2.8 per cent! The comparison between the US and Germany is stark and as follows. Germany has a currency appreciation of 27 per cent and an inflation rate acceleration from 1.8 to 2.8 per cent. The US has a 25 per cent depreciation and an inflation rate acceleration of only 0.4 percentage points. So much for the inflation anchoring tough monetarists in the ECB.

Given its legendary, and most often self-congratulatory, status as a monetarist inflation fighter, this bad performance is somewhat shocking "" which is why the award for the worst Central Bank is awarded to them. (Their policies are not much known for growth either.) It should also cause some honest soul-searching among policy wonks about how the world has changed, and about how some of the old knee-jerk policy rules no longer apply. It should also pause the exchange rate fundamentalists from believing the simple, and perhaps too simplistic, notions of exchange rate pass-through.

But what does this all mean for policy making today? The news in India is just out that the year on year wholesale price index has just reached 7 per cent. In the last week or so, the government has announced several cuts in import and excise taxes. This is appropriate policy, and it is hoped that the monetary authorities do not follow the ECB logic (if they do, they need to come up with empirical logic to substantiate). This rise in international commodity prices should also allow the government of India to make fundamental changes in policy towards agricultural producers (let them go free and produce and protect the poor through direct cash transfers).

But will this bring down inflation tomorrow, as the India stock market bears, and gushy news anchors, are demanding? Obviously not, and neither would a tightening in monetary policy, and nor would exchange rate appreciation. So when will inflation come down? Over the next few months, as international commodity prices come down to earth. From its peak, wheat prices are down 33 per cent, silver prices 20 per cent, and lean hogs (important for China) 25 per cent. It is true "" what goes up in a hurry, comes down in a hurry.

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The author is Chairman, Oxus Investments, a New Delhi based asset management company. The views expressed are personal.

Surjit.bhalla@oxusinvestments.com