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Between Inflation and a Hard Place

Author: Lee Hudson Teslik
January 24, 2008

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The U.S. Federal Reserve’s recent decision to sharply cut its benchmark interest rate prompted a happy response from investors, so it may seem strange that many other central banks aren’t making similar cuts. Jean-Claude Trichet, the president of the European Central Bank, stomped out speculation (Bloomberg) that he might follow the Fed’s lead. The Bank of England’s committee in charge of interest rates voted eight to one to leave them untouched (Times of London). In Australia, media reports suggest the central bank is likely to raise rates next month (Herald Sun). The explanation is simple—inflation—but it has complex implication for policymakers.

Worldwide, central banks face tightened credit and tumbling markets, but many remain just as concerned about sudden jumps in consumer prices. Australia announced January 23 that inflation has reached levels not seen in sixteen years (FT). The Aussies are hardly alone. Even ignoring statistical outliers—Zimbabwe, for instance, where recent International Monetary Fund estimates put annual inflation at roughly 150,000 percent—major economies around the world now face strong upward pressure on consumer prices. The Economist reports that global inflation reached 4.8 percent in the year to November 2007, up from 2.8 percent twelve months earlier. In the Eurozone, inflation stands at its highest rate since the introduction of the euro currency. In the United States, inflation remains lower but jumped 1.6 percent in the year leading up to November 2007.

The developing world presents a starker picture. Venezuela struggled with inflation rates over 20 percent in 2007 (Bloomberg). Argentina and Bolivia face similar concerns. Official data puts Russian inflation for 2007 at nearly 12 percent (Forbes). Several Gulf Arab states also find themselves with inflation over or near 10 percent. In China, rates near 7 percent registered in December 2007 represent the highest inflation in over a decade. China’s Prime Minister Wen Jiabao recently announced Beijing would freeze short-term energy prices in an attempt to curb consumer price increases (NYT).

Efforts to combat the problem in China and other countries are complicated by international monetary policy. CFR Senior Fellow Benn Steil said at a recent meeting that the United States is “exporting inflation worldwide,” given the number of countries, like China and several Middle Eastern states, which peg their currencies to the dollar, and thus to U.S. monetary policy.

How much does rising inflation really matter? Potentially a lot, economists say, particularly coming at a time when central bankers face tough choices about interest rate policy. Consumer price instability can be profoundly unsettling for an economy, and the ominous prospect of inflation limits the extent to which central banks will be willing to use monetary policy to bolster banks, many of which find themselves in a mess due to stingy credit.

Experts say the uncertainty of the overall picture leaves mixed messages for U.S. monetary policy. Sebastian Mallaby, the director of CFR’s Greenberg Center for Geoeconomic Studies, notes in a new podcast that several factors, including rising energy prices and the falling dollar, create price pressure upward in the United States. At a January 24 CFR meeting, Laurence Meyer, Bank of America’s chief economist and a former Fed governor, said if the Fed uses sharp interest rate cuts to mitigate short-term market risks, it must also be willing to raise them again quickly once the initial risks have been forestalled. If it doesn’t do this, the risks of inflation stand to heighten. “If the Fed cuts interest rates too much, it could get out of control,” Mallaby says. “You’d get a repeat of the 1970s where an attempt to keep on goosing the economy with stimulative policy just created inflation.”

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