http://www.economist.com/debate/overview/203

Feb 17th 2011 | from the print edition

CHINA’S inflation rate has become one of the world’s most closely watched numbers. This week’s release showed that inflation rose to 4.9% in January, up from 1.5% a year earlier. The increase was smaller than expected, but has not quelled fears that as inflation creeps up the government will need to slam on the economic brakes. Some economists, however, believe that China should welcome higher inflation as a more effective way to rebalance its economy than a currency appreciation.

The recent surge in Chinese inflation has been driven mainly by food prices, but non-food inflation has also risen to 2.6%, its highest rate since the series began in 2001. Wages are increasing at a faster rate. For many years China’s large pool of surplus labour held average pay rises below the rate of productivity growth. But as fewer young people enter the workforce, wages are now rising faster than productivity. Arthur Kroeber of Dragonomics, a Beijing-based research firm, argues that if higher inflation reflects faster wage growth, this will help China, not hurt it.

Inflation in China is a problem for the country but not for the world

IN JANUARY 1992 Deng Xiaoping, then China’s paramount leader, arrived in Shenzhen for the start of his month-long “Southern tour”. He extolled the success of the coastal special economic zones, lambasted his reactionary opponents in Beijing and ushered in a torrid economic boom that forced inflation above 25%.

China has not suffered from double-digit inflation since. But the episode did lasting harm to the credibility of its macroeconomic stewardship. According to Jonathan Anderson of UBS, many outsiders see “the monetary authorities as unreconstructed relics of the socialist planning era without much grasp of market tools.” They fear that the economy is ‘“beyond control”, prone to speculative excesses followed by clumsy crackdowns.

China is once again stirring their fears. In the year to November consumer prices rose by 5.1%, the fastest increase for 28 months and a striking turnaround from the deflation of the year before (see chart). Higher prices are now percolating through the economy: last month Starbucks bumped up the price of a whipped-cream Frappuccino by about 6%.

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Betting big on bonds

An economist advises investors to expect deflation

THE debt crisis has presented investors with an extremely awkward dilemma. Debt ratios, relative to GDP, are so high that it seems unlikely that most developed economies can grow their way out of the mess. That leaves the unappealing options of default, Japanese-style stagnation or rapid inflation to erode the real value of the debt burden.

Selecting the right portfolio to take advantage of these different scenarios is very difficult. An inflationary outcome would encourage investors to buy commodities and sell Treasury bonds; a deflationary outcome would suggest the reverse. Equities might perform better than government bonds in the event of inflation, but might still deliver negative real returns as they did for much of the 1970s. Cash may provide security but offers virtually nothing in yield.

In a new book “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation”*, Gary Shilling, an economist, argues for the deflationary outcome. He expects American GDP growth to average only 2% over the next decade as the economy struggles to deal with the debt burden.

Inflation in the US slowed further in October, with “core” inflation – which excludes volatile food and fuel prices – up only 0.6% on a year ago.

It is the lowest year-on-year increase on record, with core prices remaining unchanged for three months running.

The core inflation measure is closely watched by the Federal Reserve as a measure of price momentum.

The all-items consumer prices index (CPI) rose 0.2% in October, bringing its year-on-year rise to 1.2%.

The higher overall CPI rate was mainly due to petrol prices, which are excluded from the core measure, and which jumped 4.6% from September, according to the US Department for Labor.

First, the government would have to decide what the price of gold is. That’s a lot harder than it sounds. In theory, there’s an ideal rate at which to peg currency against gold. We just don’t know what it is. Gold is notoriously volatile—its price has doubled over the last two years. If the Federal Reserve were to simply fix the dollar to the price of gold on a given day, and demand for gold changed drastically, it would wreak havoc on the economy. If the Fed pegs the rate too high, for example, people would want to trade their dollars for gold, forcing the Fed to raise interest rates in order to make dollars more attractive. Even if the Fed were to pick the rate correctly, it would still have to make adjustments based on the economies of the United States’ trading partners. If the dollar is growing in value, but another country’s currency is decreasing in value, yet both currencies are pegged to gold, something has to give—either one of the currencies has to inflate or deflate, or the exchange rate has to be adjusted.

Once the Fed set the price of gold, it would then have to keep the currency fixed, leaving the economy subject to the vicissitudes of the gold index. If the price of gold goes up, the United States would have to raise interest rates, which could lead to tighter credit. Which might be OK, except that gold is a primary indicator of economic uncertainty: When the economy is bad, the price of gold goes up. So the Fed would be tightening credit just when people need it most. The result: a deflationary spiral that drives the economy even deeper into recession.

So why do so many investors think that inflation might head upward? Because next week, the Federal Reserve is expected to announce a new round of quantitative easing—printing money, and possibly stoking inflation. Of course, not everyone believes the Fed’s policy will have that effect. In that case, these negative-yield bonds will be true to their name.

The problem is that the strategy is indirect. The Fed cannot just buy up goods and services, so it is trying to convince investors to invest and banks to lend more, creating more economic activity. And many prominent economists, ranging from the wonks at the libertarian Cato Institute to liberal Nobel-winner Joe Stiglitz, are skeptical. Even Fed Chairman Ben Bernanke sounds uncertain. “Monetary policymaking in an era of low inflation has not proved to be entirely straightforward,” he sighed in a speech earlier this month.

QE largely succeeded the first time the Fed used it, Bernanke says. From late 2008 through 2009, the Fed created about $1.7 trillion and used the funds to purchase debt in housing-finance firms like Fannie Mae, Treasury bonds, and a whole lot of mortgage-backed securities—tripling the size of its balance sheet to $2.3 trillion. That helped clean some bad assets from the banks’ books and reassured spooked markets. But in 2009, the government was trading cash for mortgage-related assets nobody wanted. In 2010, it wants to try to trade cash for an asset that is essentially as safe as cash. If QE2 is to work, it will have to work differently than QE did—and probably won’t work as well.

This set the stage for a period of wide trade imbalances and for the Depression that followed. America’s export prowess meant that by the end of the 1920s it held almost two-fifths of the world’s gold reserves. A cheaper currency gave French exports a lift and France built up its gold holdings rapidly. The deficit countries in this constellation were Britain and Germany. Britain’s exports struggled against an overvalued currency. The economy was further held back by the high interest rates needed to retain scarce gold reserves. Britain, like Germany, found cutting wages to make exports competitive was made harder by trade unions.

When recession came it was made worse by the strictures of the gold standard. An “unexceptional downturn then was converted into the Great Depression by the actions of central banks and governments,” say the authors. Central banks kept interest rates high to counter fears that their currencies would be devalued and to attract gold deposits. A banking crisis that had spread from Austria and Germany finally forced Britain to abandon its gold peg in September 1931. The following month the Federal Reserve raised interest rates sharply to show America’s commitment to gold. Indeed, America and France shrank their money supplies by more than was strictly necessary by liquidating gold-backed currencies from their reserves. That only increased the deflationary pressures at home and abroad.”

Jun 3rd 2010

IN THE short run inflation is an economic phenomenon. In the long run it is a political one. This week The Economist asked a group of leading economists whether they reckoned inflation or deflation was the greater threat; this was our inaugural question in “Economics by invitation”, an online forum of more than 50 eminent economists. The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts. “Deflation is not a lasting threat,” wrote Arminio Fraga, a former president of Brazil’s central bank. “The more interesting question is whether they can manage to keep inflation down over time under the regime of fiscal irresponsibility now prevailing almost everywhere.”

Creating more inflation is harder than it sounds—even if rich-world governments were tempted to try, as a solution to their fiscal problems. It requires aggregate demand to return to, and exceed, potential output. Measuring the output gap (the shortfall of actual demand compared with potential GDP) is notoriously tricky. The OECD reckons for its members it will be about 4% this year, down from about 5% last year. It has revised that estimate down since November in recognition of better-than-expected growth, especially in America. Still, the revised gap is larger than at any time since at least 1970. America’s gap was larger in 1982, but inflation today is much lower. Indeed, the OECD estimates that in each of the G7 countries, inflation will be less than 2% through to the end of next year. The process could be hurried up if inflation expectations rise. But with underlying inflation below central banks’ targets in many countries, and dropping, expectations could move down instead.