KEY POINTS:
One of the remarkable features of the past few years has been the dramatic reduction in inflation rates around the world.
Admittedly, you can find a few exceptions - Zimbabwe, for example, has an official inflation rate of 3713.9 per cent - but, for the majority of countries, price stability is a reality.
When, therefore, inflation shows signs of misbehaving, everyone starts to worry. In Britain just over a month ago, Mervyn King, the Governor of the Bank of England, was obliged to write to the Chancellor explaining why consumer price inflation had risen above 3 per cent. That letter left many commentators suggesting the bank had lost the inflationary plot, seemingly forgetting that, a few years ago, 3.1 per cent inflation would have been hailed as a remarkable success.
Nevertheless, their passionate response is a reminder that price stability is an extraordinary prize. Inflation is an unwelcome and unpleasant economic distortion. It arbitrarily redistributes income and wealth, and its volatility corrupts the price mechanism. Goods, labour and capital markets are unable to perform efficiently.
So, in the context of postwar history, the past few years have been truly amazing. As inflation has come down, global economic growth has accelerated. With most countries committed to price stability, exchange rate volatility has also declined, facilitating much higher cross-border flows of goods, services, capital and labour.
People used to think low inflation could be achieved only through much higher unemployment. We now understand better that achieving price stability is the most obvious route to lower unemployment. Remove inflationary distortions and the price mechanism works better.
Having fought so hard to achieve price stability, policymakers are not in the mood to allow this most precious of prizes to slip through their fingers.
Yet there's a heightened sense of nervousness. The Federal Reserve still isn't sure US inflationary pressures are under control. The European Central Bank is looking for chances to raise interest rates a notch or two. The Bank of England has signalled the need for higher interest rates.
In New Zealand, Reserve Bank Governor Alan Bollard has raised the official cash rate twice this year to a record 7.75 per cent to combat rising household spending and home lending. New Zealand's economy grew 2.1 per cent in the fourth quarter from a year earlier and annual inflation was 2.5 per cent in the first quarter.
China, meanwhile, worries that the rapid pace of economic expansion may, eventually, lead to a resurgence of inflationary pressures.
The odd thing about this unease is the absence of a common international framework to assess if inflation is returning. For such an important issue, the lack of any agreement on the appropriate monetary structure is disconcerting.
One possibility is that the American monetary framework, for example, works well for the US economy while the British framework is tailored to fit Britain, and the New Zealand system has been widely credited with restricting inflation.
While there may be some truth in this, I don't think it's a wholly satisfactory answer. The decline in inflation in recent years has been a global phenomenon, shared by many countries irrespective of their specific monetary frameworks.
By the same logic, it's possible inflation might eventually rise on a global basis, regardless of the specific frameworks in individual countries. And it wouldn't be the first time. Remember the inflation of the late 1960s and early 70s.
So how can we tell if inflation is about to return? The economic models typically used by central banks are not helpful. For the most part, they're cyclical models. They tell you if demand is a bit too strong or a bit too weak relative to available supply. But they have nothing very much to say about the possibility that inflation is about to rise on a structural, multi-year basis, as it did in the 1970s.
Put another way, they assume price stability is here to stay, whatever happens domestically or globally.
This approach can't be right. These models are mathematical sycophants. With them, you're always on the right path, up to the moment you step over the cliff. What's needed, instead, is an approach that tells you when, perhaps, these cyclical models are in danger of breaking down.
In this area, central banks cannot agree. Most central bankers accept that it makes sense to monitor inflationary expectations but, by the time expectations rise, it's often too late: the inflation genie is already out of the bottle.
What's needed is a measure - a bit like a warning light - that tells the central banker there may be trouble ahead. One such indicator might be money supply.
I'm not suggesting we should all convert to monetarism - its teachings are too simplistic and full of quasi-religious fervour. But, should money supply growth be unusually rapid - even when inflationary expectations may seem well grounded - there is at least a case for asking if the standard economic models are being economical with the truth.
The European Central Bank has always thought this way. The Bank of England is beginning to think again about money supply. The Federal Reserve, however, is totally dismissive. Because foreign holdings of dollars are so high, and because money can be created and destroyed within the banking system without any help from the Federal Reserve's policymakers, it follows - in their view - that traditional measures of money supply say nothing of significance about current or future inflation.
This is all rather worrying. Central bankers need a warning light. The ECB and Bank of England think they've found one, in the form of money supply growth. For both, this warning light is flashing red.
In contrast, the Federal Reserve doesn't have a warning light it believes it can rely upon. Indeed, given the Fed's recent decision to stop publishing M3 data, the warning light it once had has been disconnected.
The irony is money supply growth in Britain and the eurozone may increasingly be influenced by monetary and economic decisions reached elsewhere in the world.
Inflows into London, Frankfurt and Paris partly reflect interest rate levels in Japan, foreign exchange reserves in China, Russia and the Middle East and, indeed, the monetary stance in the US. Those inflows, in turn, lift asset prices and encourage additional domestic bank lending - which, in turn, triggers the warning light.
Put another way, the decisions of others to ignore their own warning lights may leave domestic reserve banks with more monetary problems than they deserve. In response, they will do only what they know best: shove interest rates up some more. They cannot, after all, let the prize slip from their grasp.
- INDEPENDENT
