Another trap is sprung
The ‘Global Agenda’ column for February 22 was entitled ‘The Trap is Sprung’ and was devoted to the jump in US inflation. Its starting point was the policy of the Fed, the US central bank, to cut interest rates sharply in an effort to stimulate economy activity (i.e. avoid recession), although inflationary forces were actually strengthening. Since loose monetary policy is itself inflationary and central banks are supposed to prevent inflation, this would seem to be a perverse course to take. However, so severe was the threat of a major recession in the view of the Fed and its Chairman, Ben Bernanke, that they felt obliged to engage in stimulation and salvation, in the hope/ expectation that inflation would itself fall victim later in the year to the incipient recession. If this expectation of lower inflation were to prove incorrect, then the US economy would face that most dreadful of all combinations – rising prices (inflation) and declining economic activity (recession) know as stagflation.
But the Fed’s policy not only creates the environment necessary for inflation to thrive, but also cause the dollar’s value to fall and spurs investors to seek non-traditional assets such as commodities. The ensuing rise in commodity prices pushes up prices throughout the economy and ensures that inflation will get worse. Thus, by taking steps that create inflation the Fed was walking into a trap of its own making – and one that it could hardly be unaware of.
That was – and very much still is – the American story. However, at the same time, the Bank of Israel, and its Governor, Stanley Fischer, were doing very much the same thing. In Fischer’s case, however, the justification for cutting interest rates sharply in February and March was much weaker, on two grounds. First, and foremost, in early 2008 the Israeli economy was in excellent shape. There were no signs of a severe slowdown and imminent recession; it was actually hard to find signs of any slowdown at all. Second, the rate of inflation was much higher in Israel and, given the strength of the economy, seemed less vulnerable to being quashed by a slowdown that might emerge – if at all – later in the year.
Consequently, if American analysts responded to Bernanke’s cuts by warning of their inflationary impact, there was far more reason to expect Israeli inflation to remain troublesome. It should also be stressed that inflation is now a global problem. As noted in this column over recent months, countries of every size, location and political structure are reporting higher inflation. The causes of this upsurge and their expected development are subjects of legitimate and intense debate among economists, but the data are absolutely clear-cut. Inflation is happening, big time.
Yet, for some reason best known to themselves, the Israeli inflation-forecasting community decided that the Consumer Price Index would fall in both February and March, before rising again in April-May. For March they predicted a decline of 0.2-0.3%. The actual figure, published on Tuesday, was a rise of 0.3%. Whilst forecasting a single month’s index is always problematic, a blunder of this magnitude is rare. Most housewives could and surely would have done much better, but economists have more faith in computerised models than in actually trudging through super, hyper or even open-air markets. Nor do economists place any faith in markets: the fact that index-linked government bonds have risen steadily this year carries no weight with them.
The result was the usual rush of media clichés, describing ‘stunned’ officials who were ‘surprised’, nay ‘shocked’, to find inflation rising when, at least in the la-la land they had constructed, it was supposed to be falling.
Their rude awakening is their problem, but high and rising inflation is everyone’s – especially that of the poor. Prices of the basket of goods and services bought by lower-income families (think food) are rising much faster than those of the bigger basket bought by higher-income families. The rise in food prices is not a speculative play, as that of energy now probably is; it reflects basic imbalances in global supply and demand, now severely aggravated by the ‘green’ mania and its disastrous by-product, bio-fuels made from corn.
The real problem — in the US, Israel and elsewhere — is now that the wider public is realising that the promises of governments and governors that inflation will fade are unfounded, and also that the CPI has been rigged to make the inflation numbers lower than the reality. The resultant erosion of confidence will find political expression in due course; then it will be the political pundit’s turn to express ‘shock’ and ‘amazement’.