Barring a financial accident or a market meltdown, the European Central Bank looks set to raise interest rates by a quarter point on July 3. The question, though, is whether one or two small rate increases will be enough to arrest the powerful global trend toward higher prices.
The euro zone's consumer price index is currently up 3.7% – the highest in 16 years. It will likely rise above 4% this summer, twice the level the ECB deems compatible with price stability. And there is no end in sight. Most forecasts, including the ECB's own staff projections, assume that inflation is unlikely to return to the comfort zone this year or next.
Many other central banks face similar if not bigger problems. In the U.K., the CPI is likely to climb to 4% this summer. In the U.S., it looks set to breach the 5% hurdle later this year. In many emerging economies, such as Russia, Ukraine, Turkey, South Africa and Indonesia, inflation rates are already in the double digits. In more than 80% of the developed and emerging market countries that follow some form of inflation targeting, the CPI now exceeds the target.
The conventional theory is that surging food and energy costs explain virtually all of the inflation spike. Optimists claim that once energy and food prices settle down again, the overall CPI will subside as well and the current inflation scare will have been just that – a scare. But the rising price level is more than just a temporary blip. We are witnessing a shift toward a higher international inflation regime as a result of loose global monetary policy and less favorable structural forces.
During the "goldilocks" era, which started in the early 1990s and ended a couple of years ago, deregulation, globalization and accelerating productivity growth helped central banks to keep consumer prices in check. Now, re-regulation and protectionism are making a comeback, globalization is pushing up food and energy prices, and productivity growth is decelerating. Goldilocks is history; stagflation is the new reality. The real driving force behind rising global inflation is not so much a demand-led energy and food price shock but a very lax global monetary policy stance. In the advanced economies, the main culprits are the U.S. Federal Reserve and its hyperaggressive easing in response to the credit crisis, and the Bank of Japan's low interest rate policy.
Monetary policy is even easier in many Asian, East European and Mideastern countries. That's partly because several of these economies have pegged their currencies to the dollar or follow another kind of managed exchange-rate system. When the dollar plunged due to the Fed's easy-money policy, the central banks in these emerging economies could not tighten monetary policy because it would have led to an appreciation of their currencies vis-à-vis the dollar. The Fed thus de facto exported its easy-money policy and rising inflation to these countries. We have calculated that the GDP-weighted global official interest rate stands around 4.3%. With global inflation running at around 5%, the global real policy rate is negative.
It is thus hardly surprising that global inflation is accelerating. Food and energy prices have been simply the first to react to the great monetary easing. The prices of other goods and services are likely to follow. Individual countries or currency unions like the euro area will have a hard time insulating their national price levels from this global trend. Keeping inflation down will only be possible if a central bank is willing to raise rates to much higher levels and if the currency appreciates sufficiently to offset rising import prices. But exchange-rate moves are often unpredictable. And history suggests that even the most hawkish central banks have accommodated unusually high inflation rates in order not to wreck the economy. During the stagflationary 1970s, for example, even the Deutsche Bundesbank tolerated relatively high inflation levels – though lower than in most other developed countries.
Our research suggests that global factors, such as world-wide inflation trends, dominate national factors in determining national inflation rates. The growing integration of markets over the past 15 years or so has accentuated this trend further. Put simply, nowadays inflation is largely a global rather than a local phenomenon.
Of course, a central bank could still keep inflation on track over the medium term. But given the low responsiveness of national inflation to domestic economic conditions, the bank would have to engineer a major recession to counter the global inflation trend. Most central banks probably lack the resolve to do so.
By signalling a rate hike in July, Jean-Claude Trichet has sent the message that the ECB won't just stand by and watch as inflation reaches new highs. Yet, unless other central banks join the tightening bandwagon, the ECB's impact on euro-area inflation is likely to be minimal. Also, since the ECB upped its hawkish rhetoric, the euro's external value has weakened rather than strengthened. The risk is that whatever impact a small rate hike may have had on inflation will be canceled out by a weaker euro, which will lead to higher import prices.
This raises the question whether the ECB's inflation target and those of other central banks are overly ambitious. Most of these targets were adopted when favorable structural forces kept inflation low. Paying lip service to these targets but missing them for a prolonged period will eventually harm the central banks' credibility.
Instead, policy makers should acknowledge that global forces will lead to somewhat higher inflation over the medium term and adjust inflation targets accordingly. If carefully explained and coupled with a promise to make good for potential overshoots of the higher target by undershooting it at other times, the ECB can retain the public's trust. Testing times for Trichet & Co.
Joachim Fels is chief global fixed-income economist at Morgan Stanley.