Sunday, May 1, 2011

Again on inflation

Ryan Avent at the Economist points us to a NY Fed report and an IMF working paper showing why headline inflation is likely to have no impact on core inflation, and so inflation in the long run. But first of all, I thought that would be interesting to recap the arguments on inflation, deflation, etc...

Why do we care about deflation? Krugman here
Why does deflation have a depressing effect on the economy? Two reasons. First, it reduces money incomes while debt stays the same, so it worsens balance sheet problems, reducing spending. Second, expectations of future deflation mean that any borrowing now will have to be repaid out of smaller wages (if the borrower is a household) or smaller profits (if the borrower is a firm.) So expected future deflation also reduces spending.

Why do we care about inflation? The SF Fed helps us:
What's so bad about higher inflation?
High inflation is bad because it can hinder economic growth, and for a lot of reasons. For one thing, it makes it harder to tell what a change in the price of a particular product means. For example, a firm that is offered higher prices for its products can have trouble telling how much of the price change is due to stronger demand for its products and how much reflects the economy-wide rise in prices.
Moreover, when inflation is high, it also tends to vary a lot, and that makes people uncertain about what inflation will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds an inflation risk premium to long-term interest rates, and it complicates further the planning and contracting by businesses and households that are so essential to capital formation.
That's not all. Because many aspects of the tax system are not indexed to inflation, high inflation distorts economic decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of economic activities. In addition, it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities.
Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates, a surprise inflation redistributes wealth from lenders to borrowers, because inflation lowers the real burden of making a stream of payments whose nominal value is fixed. 
Basically, what you want is small and stable expectations of inflation. And the main issue with that is the wage-price spiral. As a consumer, if you expect more inflation, you'll ask for a higher wage. If you're a firm, a higher wage means that you'll raise prices. That's why you want to anchor inflation expectations.

The main worry today, as I mentioned in previous posts, in the rise in headline inflation. The issue would be if the headline inflation feeds into the core inflation. The way this can happen is if the expected rise in headline inflation leads to a rise in wages. This is not happening.

The NY Fed explains that
 [Y]ear-ahead median wage growth expectations have remained muted since February 2009.
Interestingly, their research indicates that the expectation of high inflation is some surveys like the Michigan Survey of Consumers is due to the actual wording of the question. Basically, the responses you get when asking consumers about their expectations of inflation are different if you ask about prices in general and the rate of inflation. They provide an interesting table:
Table1 
This is exactly what you see in the graphs showing core and headline inflation, that I mentioned here and there. The correlation with cyclical factors is just not there. This is one reason why wages are not growing at the rate of headline inflation right now. The second reason is that unemployment is still high: workers have no bargaining power. The IMF paper explains that

Overall, the historical patterns suggest little upside inflation risk in  advanced economies facing the prospect of persistent large output gaps. 

 This is what you see, meanwhile, in Germany, and this is what is driving the ECB decision to rise interest rates(this is the only one that makes sense). Have fun and google "Germany Labor Shortage". Germany's unemployment rate is at its lowest in 20 years. It lacks skilled labor. It opened its borders to Eastern European workers today. I am looking for data on the output gap in Europe(can't find it), but the WSJ is quoting a Goldman Sachs report suggesting that the US has double the output gap of European countries.I am not sure of what that entails, but consider that the average Euro output gap is "between 3% and 4%" and that Germany is at full employment, and you can think that some other European countries are far from suffering from an inflation spiral.

The policy of the ECB is only linked to Germany's situation. This probably makes sense, since it shows signs of over-heating. What it means is that the solution to this problem(no, it's not quitting the Euro) is probably with more fiscal and economic integration in the Euro-zone. Note that even in Germany, you have full employment in the West but the unemployment rate is still 10% in the East. It is quite unlikely that the structural employment in Spain is 20%.  A greater mobility within the Euro Area, and an harmonization of fiscal policies(say, corporate taxes), is desirable, but, apparently, not desired.

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