Ben Bernanke, head of the US Federal Reserve, devoted much of his academic career before becoming a central banker to the study of deflation in the 1930s. He has also been a keen student of the Japanese economy since the bursting of the stock market and property bubbles in the 1990s. So his response to the credit crisis that broke in August last year drew closely on the lessons of these two episodes. The Fed pumped liquidity into the markets and opted for an early and substantial cut in interest rates. The general assumption among economists has been that a prolonged period of low interest rates is essential in addressing the seize-up in the banking system and the related decline in housing markets in the US, the UK and elsewhere.
That assumption can no longer be taken for granted because inflation has made a global comeback. The most tangible evidence of the renewed pressure on prices is to be found in the energy and food markets. Increased demand resulting from the extraordinarily rapid growth in China, India and other emerging markets is the chief explanation. But inflation is a monetary phenomenon. It is clear that monetary policy in the US is loose. And because so many developing countries peg their currencies to the dollar, US monetary policy has been transmitted to much of the global economy. The outcome is that the world looks increasingly as it did in the 1970s when a combination of economic stagnation and inflation - known as “stagflation” - blighted the world economy.
This is a remarkable change in the way the global economy works. Until recently the industrialization of China and other emerging markets had the helpful effect of putting a lid on wages in the developed world. We can now see that the period from 1997 to 2006 was freakishly benign for developed countries. The Asian financial crisis of 1997-8 reduced demand for commodities, so that the developed world imported less commodity price inflation. The China effect delivered a big improvement in the developed world?fs terms of trade as falling import prices lowered domestic inflation.
As Stephen King of HSBC has argued, the low rate of inflation over this ten year period was not, as some would like to believe, a tribute to the acumen of independent central bankers. The job of keeping consumer prices down was being made easy for them. And because central banks were able to keep interest rates low without sparking rises in the general price level, they caused asset prices to rise, first in the equity market in the late 1990s, then in the property markets in the first half of this decade. An excess of savings over investment in the emerging markets and the petro economies added further impetus to the rise in asset prices as investors pursued yield with less and less regard for risk. As we now know, this led to the greatest credit bubble of all time. Lending standards, whether in the housing market, leveraged buyouts or consumer credit, collapsed. Then came the bursting of the bubble last year and a process of de-leveraging that is still under way. Extreme caution prevails in the banking systems of North America and Europe, while investors?f risk appetite has waned.
Since the rescue of Bear Stearns, the troubled investment bank, in March, the worst of the financial crisis appears to be over, even if interest rates in the inter-bank market remain high in relation to policy rates. But the focus is now on the impact the credit crisis is having on the real economy in those countries that experienced the biggest housing and real estate booms. In the US and the UK the stage is set for two or three years of below-trend growth. All of which leaves the central banks with an acute dilemma. Low interest rates are needed to prevent economies from slipping into recession or deflation. But high interest rates are needed to confront renewed inflation. The scope for policy error is thus very great. After a decade in which the control of consumer prices was an easy task, the central bankers are suddenly in difficult territory.
This is particularly true in the emerging markets, which are the real engine of today?fs global inflation. Countries whose currencies are pegged to the dollar are overheating. China has been growing at an astonishing real rate of 10.5 per cent, with consumer prices rising at close to 8 per cent and wages seeing double digit increases. That story is being repeated on a slightly less spectacular scale across the developing world. And since these economies are now much larger than they were a decade ago, this matters a great deal for the developed world.
Monetary policy in China and other emerging markets is simply too loose. But the central banks in such countries are rarely independent and do not have well established inflation targeting regimes. Raising rates would anyway inflict considerable hardship on populations that remain very poor. While policy may tighten, the risk is that it will be too little, too late.
The risks in the developed world where, with the notable exception of a recovering Japan, the central banks are struggling in the face of stagflation, are rather different. What is clear, in the light of the recent credit bubble, is that monetary policy will in future have to be more sensitive to movements in asset prices. And the worry for the future is that the independence of central banks could come under threat from the politicians if the response to stagflation errs on the side of anti-inflationary overkill. Mr Bernanke, in a well worn phrase, is caught between a rock and a hard place.