A new paradigm for inflation

January 14, 2011

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

Looking through the minutes of the Bank of England’s policy meetings for the past year, there are a couple of patterns that you see emerge. Firstly, that rates are on hold, and secondly, that the UK’s elevated inflation rate is temporary. Now the European Central Bank has joined the chorus. ECB President Trichet recently sounded confident that prices will moderate, even though consumer prices rose above the ECB’s target rate of 2 per cent in December.

But how long will citizens of Europe and the UK accept rising prices and how long can central bankers continue to stand by while inflation smashes their target rates? To answer this we need to find out two things: firstly, is this rise in inflation really that bad? Secondly, why are central bankers willing to let inflation pass them by without exercising monetary control?

Inflation is a tricky thing to get right. A little is good since it helps growth, but not enough is bad as it can stunt an economy and leave it in a deflationary spiral. There is also another benefit to inflation: it helps to erode debt levels in real terms. When many developed economies are struggling with unsustainable debt loads, a little inflation helps to lower the size of the mountain.

But prices are rising at a 3.3 per cent annualised rate in the UK. While the Bank of England rightly points out that this is due to commodity prices, but its assertion that inflation will prove temporary has been incorrect for more than a year.

Commodity super-cycle:

We are in a super-cycle for commodities. Burgeoning demand for food and raw materials from the fast-growing emerging world is set to dominate demand for commodities for the next few years, possibly even for the next generation. This means that people in the west who were used to low prices for most of the last decade will have to get used to coughing up at the supermarket and at the petrol pump for a while yet.

The commodity super cycle works like so: the surge in the cost of foodstuffs including wheat, sugar and meat is due to the rapidly expanding middle classes in emerging market powerhouses like India and China. Likewise, oil prices are rising as industry and car use expands in these economies. This demographic group is one of the single most important factors fueling commodity demand for the next decade. Their spending power is driven by wage inflation in emerging markets, so western consumers face higher prices on the back of rising living standards in the developing world.

New Paradigm for inflation in western economies:

This is undoubtedly something to celebrate. But it means that western economies have to adapt and get used higher prices. Perhaps this explains the reticence of the Bank of England to raise interest rates. Due to global developments outside of its control growth remains fragile while prices rise, and Mervyn King and co can’t do anything to halt the latter phenomenon. Trying to reduce UK demand with higher interest rates is unlikely to reduce commodity prices (the UK isn’t where the bulk of demand is coming from) yet it would do a huge amount of damage to small businesses, investor confidence and the upward pressure this would put on the pound would harm UK exporters’ competitiveness in the global economy.

Central bankers in the developed world need to adapt to a new paradigm whereby their economies are not the main drivers of world growth. This requires a different approach to monetary policy – one where headline or commodity based inflation remains elevated for a prolonged period (a matter of years), while core inflation pressures remain moderate. Central Bankers will only need to act once core inflation – or wage prices- start to rise rapidly. The Bank of England seems to be pursuing this strategy, but they can’t say so because admitting we have to get used to higher prices for essential items is politically untenable. But it is undeniable in a commodity super-cycle that we in the west will have to get used to our wallets feeling a little lighter.

Looking through the minutes of the Bank of England’s policy meetings for the past year and there are a couple of patterns that you see emerge. Firstly, that rates are on hold, and secondly that the UK’s elevated inflation rate is temporary. Now the European Central Bank has joined the chorus. ECB President Trichet recently sounded confident that prices will moderate, even though consumer prices rose above the ECB’s target rate of 2 per cent in December.

But how long will citizens of Europe and the UK accept rising prices and how long can central bankers continue to stand by while inflation smashes their target rates? To answer this we need to find out two things: firstly, is this rise in inflation really that bad? Secondly, why are central bankers willing to let inflation pass them by without exercising monetary control?

Inflation is a tricky thing to get right. A little is good since it helps growth, but not enough is bad as it can stunt an economy and leave it in a deflationary spiral. There is also another benefit to inflation: it helps to erode debt levels in real terms. When many developed economies are struggling with unsustainable debt loads, a little inflation helps to lower the size of the mountain.

But prices are rising at a 3.3 per cent annualised rate in the UK. While the Bank of England rightly points out that this is due to commodity prices, but its assertion that inflation will prove temporary has been incorrect for more than a year.

Commodity super-cycle:

We are in a super-cycle for commodities. Burgeoning demand for food and raw materials from the fast-growing emerging world is set to dominate demand for commodities for the next few years, possibly even for the next generation. This means that people in the west who were used to low prices for most of the last decade will have to get used to coughing up at the supermarket and at the petrol pump for a while yet.

The commodity super cycle works like so: the surge in the cost of foodstuffs including wheat, sugar and meat is due to the rapidly expanding middle classes in emerging market powerhouses likeIndia and China. Likewise, oil prices are rising as industry and car use expands in these economies. This demographic group is one of the single most important factors fuelling commodity demand for the next decade. Their spending power is driven by wage inflation in emerging markets, so western consumers face higher prices on the back of rising living standards in the developing world.

New Paradigm for inflation in western economies:

This is undoubtedly something to celebrate. But it means that western economies have to adapt and get used higher prices. Perhaps this explains the reticence of the Bank of England to raise interest rates. Due to global developments outside of its control growth remains fragile while prices rise, and Mervyn King and co can’t do anything to halt the latter phenomenon. Trying to reduce UK demand with higher interest rates is unlikely to reduce commodity prices (the UK isn’t where the bulk of demand is coming from) yet it would do a huge amount of damage to small businesses, investor confidence and the upward pressure this would put on the pound would harm UK exporters’ competitiveness in the global economy.

Central Bankers in the developed world need to adapt to a new paradigm whereby their economies are not the main drivers of world growth. This requires a different approach to monetary policy – one where headline or commodity based inflation remains elevated for a prolonged period (a matter of years), while core inflation pressures remain moderate. Central Bankers will only need to act once core inflation – or wage prices- start to rise rapidly. The Bank of England seems to be pursuing this strategy, but they can’t say so because admitting we have to get used to higher prices for essential items is politically untenable. But it is undeniable in a commodity super-cycle that we in the west will have to get used to our wallets feeling a little lighter.

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