Prospects of Inflation in Emerging Markets - Like the U.S.

By Simon Johnson

There are two ways to think about inflation in today’s economy. The first, suggested by conventional macroeconomic frameworks for the US, is that, with rising unemployment and actual output sinking further below “potential” output, inflation will stay low - and we could actually experience the dangers of falling wages and prices (think what happens to mortgage defaults in that scenario). This is the view, for example, expressed by Fed Vice Chair Don Kohn last week, and the Obama Administration seems to be on exactly the same page - talking already about a further very large fiscal stimulus.

Some people in this camp do see a danger of inflation, down the road, as the economy recovers - and resumes its potential level (or growth rate). As a result, many of them stress that the Fed will need to start “withdrawing” its support for credit and raising interest rates as soon as the economy turns the corner. One informed insider’s reaction to our piece on Ben Bernanke in the Washington Post on Sunday was that we were too easy on Bernanke for failing to tighten monetary conditions as the economy began to recover after the last big easing earlier this decade (specifically, our correspondent argues that Bernanke provided the intellectual underpinnings for what Greenspan wanted to do.)

In today’s post-G20 summit situation, some of my former IMF colleagues are worried that further monetary easing around the world will create inflationary pressure in middle-income emerging markets, where inflation is often harder to control than in richer “industrial countries.” But if you think the broader political and economic dynamics of the United States have become more like those of emerging markets, e.g., the concentrated power of the financial elite and their ability to access corporate welfare, doesn’t that also have potential implications for inflation?

In discussions of emerging markets, you rarely hear discussion of “potential output.” This is a slippery concept even for the United States, with origins in the idea of running factories at “full capacity” but also reflecting the traditional bargaining power of labor - macroeconomists argue about the exact reasoning but most agree it’s a magical place where inflation is stable. If output (or growth) is too high relative to potential, inflation rises and, depending on where you are relatively to some sort of inflation goal, the central bank needs to tighten monetary policy in order to bring it down.

Emerging markets traditionally experience big movements in relative prices (e.g., entire sectors collapse), big ups and downs in credit (i.e., regular banking crises and recoveries), and waves of government bad behavior (think expropriation of people’s pensions or other assets). Potential output simply isn’t stable, or perhaps even measurable, in situations with a lot of investment (in good times) and much disinvestment or scrapping of capital (when times turn sour).

So what determines inflation in emerging markets? This is simple, but also very hard to manage: the balance of supply and demand for money. The government issues money through its financing of budget deficits and various credit-support operations; this obviously tends to push up inflation (i.e., more money tends to reduce the value of money outstanding). People’s demand for money depends on what they expect in terms of inflation, and this is often affected by what the exchange rate is doing - a depreciating currency both raises the prices of imports directly and moves people’s inflation expectations upwards. In the background, of course, a growing economy has an increasing demand for money, so the economy can handle - and perhaps even needs - money issue. In practice, policymakers watch the inflation rate like a hawk and move rates up or down accordingly - but subject to the political pressures coming from higher or lower growth, perhaps relative to their perception of “trend” but without reference to any kind of “potential” concept.

What kind of economy is the US today? The financial sector has taken a huge hit and is almost certainly going to contract. The credit system remains disrupted and levels of investment are almost certainly down across the board. Many firms, nonprofits, and consumers overexpanded relative to what they now see as their more permanent prospects, so there is a big move to “repair balance sheets” (pay down debt; invest less). Potential output, if that is still a meaningful concept for the US, must be falling; and potential growth (based on some idea of where productivity can go) must also be down.

Even more important in the short-run, inflation expectations are on the move. There are different ways to think about this (naturally elusive) concept, but take a look at the latest data from the inflation swap market (we’ll do an explainer on this; for now, just look at how expectations have rebounded already from their low at the end of last year; if you want technicalities on this market, try the beginning of this document). If you prefer to focus on the implied inflation expectation in indexed 10 year US Treasury bonds this stood at 1.4 percent on Friday and shows a similar rebound over the past few months. (For some reason, my official colleagues prefer bonds; my financial market friends prefer swaps.)

As we explained in our Washington Post article yesterday, we strongly support what Ben Bernanke is doing - there is a lot of uncertainty and the alternatives are much worse. But we don’t accept the premise that the Fed’s actions today cannot cause inflation quite soon. Arguing more about this, here and elsewhere, should help us think about how to manage the consequences and minimize the costs.

Excessive inflation is a typical outcome in oligarchic situations when a weak (or pliant) government is unable to force the most powerful to take their losses - high inflation is, in many ways, an inefficient and regressive tax but it’s also often a transfer from poor to rich.

Comments

[fxmaven:]

Not just inflation, but also currency devaluation which leads to inflation. Political and Economic elites can hedge their currency risk.

Luckily USA can substitute for imports, so the "luxury goods" inflation is usually limited to those who can afford it. With the one exception of Oil.....

Apr 06 04:23 PM

[Tom Colangelo:]

BIGGER FOOL THEORY drives today’s investing:

IF I BUY IT TODAY, A BIGGER FOOL WILL BUY IT FROM ME TOMORROW AND GIVE ME A PROFIT.

THIS IS WHAT BUBBLES ARE MADE OF AND THIS IS WHY THE BEAR MARKET WILL RETURN, IN A FEW WEEKS, WHEN SMART INVESTORS GET OUT BEFORE THE LACK OF FUTURE DIVIDENDS AND GROWTH BECOME EVIDENT TO THE BIGGER FOOLS!

If not for the BIGGER FOOL THEORY, why else would people be buying FORD which will NOT pay a dividend for the next 5-7 years and has NO CHANCE of meaningful growth over the same period especially with new competitors from India, etc.?

If not for the BIGGER FOOL THEORY, why else would people be buying the large money center banks which will NOT pay a meaningful dividend for the next 3-5 years? Especially when it is clear that the markets that gave them so much growth and profits over the last 10 years, i.e. subprime mortgages, credit cards, intuitional investing, will NO LONGER be their cash cows because of the newfound diligence of the U.S. regulators who will severely restrict their irresponsible behavior that got the banks BIG PROFITS at our expense vies-a-vie BIG BAILOUTS.

If not for the BIGGER FOOL THEORY, why else would people be bidding ALCOA up last week, when the world’s largest alum producer in CHINA is closing down plants because of lack of worldwide demand?

We are going to be in a recession for the next 2-3 years so who needs more aluminum; not for cars, not for appliances, not for airplanes…then for whom will ALCOA be making more products to justify the rising stock price? THE BIGGER FOOL, that’s who!

Apr 06 05:28 PM

[Fighting Yoda:]

Inflation is dead for the next couple of years – surplus capacity, falling demand, job losses, falling wages.

All roads lead to DEFLATION – commodity/home/auto prices, Treasury/TIPS clearly point to that.

Apr 06 05:35 PM

[Stone Fox C...:]

the gov't will need to start withdrawing the credit it has extended these last 6 months. Hopefully, though it understands that most of the inflation pressures we're likely see results from supply side issues and not demand. In that scenario, they need to make sure they don't starve the US economy just b/c we spent the last 20 years blowing off all infrastructure improvements.

Apr 06 05:46 PM

[@TexasER:]

Wow, good article.

Talking about a single measure of price inflation in such a complex economy is like summing up the weather in a region with average annual temperature.

Housing prices could easily continue to decline along with personal services. But auto prices could skyrocket as manufactures drastically scale back production, thereby losing great economies of scale.

And remember all of those dollars created out of thin air aren't chasing anything--yet.

Apr 06 05:58 PM

[Socialism c...:]

"We strongly support what Bernanke is doing..."

That alone is enough to discredit you as an economist, IMO, and steer me away from your future articles!! Keynesian econ is fraudulent, socialist, and un-American!!!

Apr 06 06:24 PM

[mac.barron:]

Inside @TexasER's comment is a great point: net inflation can occur even if prices in some sectors are moving down.

Housing will keep correcting for at least a couple of years but food and energy are bound to start moving up in the same time frame.

Most manufacturers are quite sophisticated and they know the price point where they start to lose money on their products. Eventually, even if sales are flagging, they all hit a point where it doesn't make sense to go any lower. They will simply shutter their factories. This loss in capacity will, naturally, lead to shortages and the surviving suppliers will begin to jack up their prices. All this to say that you can have inflation with a shrinking market supply.


On Apr 06 05:58 PM @TexasER wrote:

> Wow, good article.
>
> Talking about a single measure of price inflation in such a complex
> economy is like summing up the weather in a region with average annual
> temperature.
>
> Housing prices could easily continue to decline along with personal
> services. But auto prices could skyrocket as manufactures drastically
> scale back production, thereby losing great economies of scale.
>
>
> And remember all of those dollars created out of thin air aren't
> chasing anything--yet.

Apr 06 09:38 PM

[Moon Kil Woong:]

With the $500 trillion popping derivatives market, no amount of money the government makes will cover the losses or staunch the de-leveraging cycle. The only very dangerous thing is that so far the government hasn't done much to prevent it from rolling over causing an eternal nightmare.

Geithner says he will regulate it but I'm still holding my breath for the tax cheat to do something honest for once.

Apr 07 12:18 AM

[Hot Richard:]

@Socialism cannot compete,
"Keynesian econ is fraudulent, socialist, and un-American!!!"

Ahhh...but what is "American"? I see the American democracy producing exactly what it deserves and therefore it is exactly (today) what it means to be "American".

You can say it (Keynesian) is anti-capitalist. You can say it is protectionist. You can say it is socialist and a nanny-state and wealth-redistribution and a Ponzi-scheme. But, you cannot say it is un-American because we have absolute proof that America is what it is. Look at Congress as it behaves today and THAT is America. Any other belief is just believing in unicorns.

@ author Simon Johnson,
Please begin with a detailed definition of what inflation is. Not all have the same definition.

As for the rest of this mess, the ONLY path that remains is wealth obliteration and redistribution (NOT production...we don't have the stomach for it). Devaluation of the dollar is part of both obliteration and redistribution.

I know, I have a bad case of the Mondays. :-(

Apr 07 11:41 AM

[Chris B:]

Inflation can easily be controlled by any government with the willpower to do it. Governments can just raise rates (perhaps to double-digits as in the early 80's U.S.) and sell assets such as bonds (reducing the amount of cash in the market). At this point, the US has plenty of room to raise rates when needed, and the government owns trillions of dollars of bonds and other salable assets, thanks to the bailouts.

It's the willpower thing that is the problem. Most politicians lack the courage to allow their central banks to basically engineer a recession like Paul Volker did in the early 80's. He was successful at ending double-digit inflation, but at the price of short term double-digit unemployment. That double-digit unemployment reversed within a few quarters as growth took off in the new low inflation, high government spending environment of the late 80's-90's.

Yet, the 1970's are a story of political dithering. Interest rates were raised, then lowered, allowing inflation to fester. Meaningless political slogans like "Whip Inflation Now" took the place of monetary policy because nobody wanted to be responsible for the effects of monetary contraction.

It could happen again... yes. But after 3 devastating bubbles caused by loose monetary policy (tech, energy, real estate), I suspect the bias has shifted from expansionary policies to contractionary policies.

Apr 07 03:53 PM

[Alan Young:]

Not being an economist, I am probably failing to appreciate the nuances of the argument here--maybe the author, or someone, can clarify the punchline:
"high inflation is, in many ways, an inefficient and regressive tax but it’s also often a transfer from poor to rich."
I understand that inflation transfers value from creditors to debtors. The poor are rarely creditors; it's the financial institutions who are most at risk, I would think.
Yes, it's hard on the poor (and retired) when prices go up. But wages and benefits can go up with inflation, too.
Am I missing something?

Apr 07 04:39 PM

[John Slater:]

Excellent post. Prior to the crash the U. S. economy was overconsuming by something like 7% of GDP. There are a variety of ways for this to adjust, including in the better scenario, an increase in output in excess of consumption. Unfortunately this type of correction will continue to be impeded, at least in the goods producing sectors, until the Yuan valuation imbalance is resolved. Stagnant incomes and price inflation will have a somewhat similar impact and presumably will eventually result in improved margins and increased business investment, though in a much less efficient and more painful way.

On a related point, I am struck by how little attention is paid to a quirk in the U. S. price deflator that has masked both the inflation that occurred a few years back and the deflation that has been occurring in the more recent past. It is now obvious that a massive revaluation of cash flows (inflation) took place from the mid-1990's when personal net worth to personal income was about 5x until 2007 when the ratio reached 6.3x. With this ratio back to 4.8x at the end of 2008, we have now come full circle (deflation). This massive inflation in the value of investment assets never showed up in CPI, nor has the dramatic collapse of these values in the last eighteen months. CPI reflects housing costs as a rental equivalent and missed both the rapid runup of housing costs as well as the decline. Securitized investment assets don't show up at all. I would argue that we have already seen a dramatic deflation, which will soon run its course as housing prices bottom, setting the stage for your predicted resumption of measurable inflation.

Apr 07 04:50 PM

[doubleguns:]

The vast sum of money sitting in our treasury bonds right now is mind boggling. When inflation starts or the dollar falls (still inflation) those bonds are going to be dumped. Then the dollar will either begin to fall or fall faster. Right now the dollar is a haven for currencies of many nations. That will change and it will be ugly I believe, about like a third world country.

Apr 07 06:06 PM

[dw57:]

not if demand destruction keeps up with supply destruction which could happen if deflation keeps going at its current rate


On Apr 06 09:38 PM mac.barron wrote:

> Inside @TexasER's comment is a great point: net inflation can occur
> even if prices in some sectors are moving down.
>
> Housing will keep correcting for at least a couple of years but food
> and energy are bound to start moving up in the same time frame.
>
>
> Most manufacturers are quite sophisticated and they know the price
> point where they start to lose money on their products. Eventually,
> even if sales are flagging, they all hit a point where it doesn't
> make sense to go any lower. They will simply shutter their factories.
> This loss in capacity will, naturally, lead to shortages and the
> surviving suppliers will begin to jack up their prices. All this
> to say that you can have inflation with a shrinking market supply.
>

Apr 07 08:30 PM

[dw57:]

maybe that incomes haven't been rising? and they are now at the same level they were in 2000 not accounting for inflation? when you account for that, incomes are less than in 2000


On Apr 07 04:39 PM Alan Young wrote:

> Not being an economist, I am probably failing to appreciate the nuances
> of the argument here--maybe the author, or someone, can clarify the
> punchline:
> "high inflation is, in many ways, an inefficient and regressive tax
> but it’s also often a transfer from poor to rich."
> I understand that inflation transfers value from creditors to debtors.
> The poor are rarely creditors; it's the financial institutions who
> are most at risk, I would think.
> Yes, it's hard on the poor (and retired) when prices go up. But wages
> and benefits can go up with inflation, too.
> Am I missing something?

Apr 07 08:34 PM

[Tetrapod:]

I agree with you that the truth of that statement is not self-evident. I think it's based on the concept that inflation benefits those who see the new money first (i.e. government -> banks -> wealthy) and who get to spend the new money for goods that have not inflated yet. Those who see the new money last (i.e. through wage increases) typically pay inflated prices for goods before they see their wages increase. If the inflation then stops, all will become equal again, but typically inflation is an ongoing process which continually benefits the early recipients of new money (i.e. the wealthiest). That much is true, but your point about debtors vs. creditors is also true, and is a force operating in the opposite direction. The balance of the two forces is not clear, and is probably distributed unevenly throughout society.


On Apr 07 04:39 PM Alan Young wrote:

> Not being an economist, I am probably failing to appreciate the nuances
> of the argument here--maybe the author, or someone, can clarify the
> punchline:
> "high inflation is, in many ways, an inefficient and regressive tax
> but it’s also often a transfer from poor to rich."
> I understand that inflation transfers value from creditors to debtors.
> The poor are rarely creditors; it's the financial institutions who
> are most at risk, I would think.
> Yes, it's hard on the poor (and retired) when prices go up. But wages
> and benefits can go up with inflation, too.
> Am I missing something?

Apr 08 08:16 AM

[Chris B:]

Inflation is a regressive tax because it forces poorer consumers to hold more cash, which ironically is depreciating more rapidly. If bread goes from $2 to $10, you have to hold an extra $8 in your checking account so you can eat next week. Now multiply that to cover each of your expenses! Now increase that amount each quarter!

For poorer and middle class consumers, this checking account / wallet account dedicated to covering living expenses represents a much larger percentage of their net worth than for the rich - maybe 10-100%.

For the rich, a relatively small percentage of wealth is held as cash. Perhaps 1-10%. The vast majority of their wealth is invested in businesses, bonds, treasuries, equities, real estate, education loans, etc. - productive assets that usually more than compensate them for a small loss of purchasing power each quarter. Yes, inflation can affect those assets, but in an inflationary environment, productive assets historically outperform just holding currency earning zero interest.

A bond yielding 3% means its owner loses nothing from 3% inflation. The guy who maintains 50% of his net worth in his checking account, however, loses 1.5% of his net worth every year. In summary, purchasing power changes this way: rich = 0%, poor = negative 1.5%.

If inflation increases, bond yields usually increase too, maintaining a spread. A checking account or wallet, however, will still yield nothing. In fact, you'll have to hold more money in it to cover higher expenses. At 10% inflation and bond yields, the change in purchasing power in the example above is: rich = 0%, poor = negative 5% (in reality, bond yields are usually 2-5% higher than inflation, which even further helps the rich.).

Thus the higher inflation goes, the wider the spread between the financial performance of the rich and poor.

Apr 08 01:59 PM

[Hot Richard:]

Chris B.
Nice post, but...
"Inflation can easily be controlled by any government with the willpower to do it."

No government has the willpower to do it (as you note), therefore; it cannot (and won't) be easily controlled.

America didn't need "Volker's recession" to curb inflation. You have to hold accountable government fiscal and monetary policies as THE CAUSE before you sigh and say "Well, I guess the only solution now is a recession!" Bull. America needed a better government. Still does, but doesn't have it.

On another point, the slight deflation we have seen is due mainly to oversupply. Go ask your local car dealer about his inventory velocity and you will understand the deflation. This is temporary and in no way should distract you from the massive inflation tunnel light blinking its light at you. Inflation is a wealth obliterator, wealth transfer machine, and probably the most criminal thing a government (controlling currency) can do to its citizens short of murder.

I've also seen some massive deception in the term "adjusted for inflation" (already). Always ask how they adjusted! Do NOT trust the dollar.

Apr 10 10:01 AM