Wrong to focus on consumer prices

In: Uncategorized

17 Aug 2009

This is my comment from this week’s Fund Strategy. I also wrote a cover story which is a guide to the debate on global economic imbalances

Rumbling beneath the surface of the current discussion on economic prospects is a debate about inflation and deflation. Some warn that inflationary pressures are likely to emerge soon, while others insist deflation will remain a key problem for the foreseeable future.

Those most concerned about inflation are generally free marketeers. They worry that the authorities are pumping vast amounts into the economy to bolster activity. Their actions include public spending, low interest rates and quantitative easing.

This huge fiscal and monetary boost is, according to critics, likely to bolster inflation within a year or two. The money supply is increasing far faster than the economy’s capacity.

Those who focus on deflation counter that such an outlook is economically illiterate. The key problem with the economy, they argue, is the enormous amount of spare capacity. At present, any stimulus is likely to have the beneficial effect of putting some of this capacity to work. Now is not the time, they say, to worry about curbing spending or raising interest rates. Such action can be taken when the economy has started to recover.

In reality, there is likely to be an unpleasant combination of inflation and deflation. Certain prices could rise sharply, while others fall in a stagnant economic environment.

The narrow focus on consumer prices obscures the fact that this is already happening to some extent. The recovery of equity prices in recent months can be seen as a form of inflation. Only rising equity prices are rarely condemned because investors are generally happy to see good returns on their investment.

In any case, the focus on prices is a narrow way to look at the economy. Changes to the price level are the result of more fundamental economic factors.

For instance, falling prices can be a sign of economic strength or weakness. If they reflect higher productivity through investment in new machinery they are welcome. The falling costs of computer processing power is a welcome development, rather than a problem. In contrast, if prices fall because an economy is stagnant that suggests something is wrong. The context is all important in assessing the significance of changing prices.

From this perspective, the overwhelming focus on inflation in contemporary economics is misplaced. The importance the Bank of England attaches to its quarterly Inflation Report is just one example of this narrow outlook. In America, the Federal Reserve attaches a similar exaggerated importance to monitoring inflation.

There are far more fundamental economic questions than whether consumer prices look likely to rise or fall.

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