The Inflation Enigma



By Barry Edwards

The Inflation Enigma


There has been a lot of discussion recently by economists and commentators about inflation and why it is not reacting as the current economic models predict. As the IMF gather in Washington for their annual meeting, this subject has become the main topic for finance ministers and central bankers who usually attend this event. The economic theory that has been the basis for managing an economy is about 30 years old and since the financial crisis in 2007/8 it has not performed according to the model making it difficult to predict how an economy will react in the next year or so.

As we discussed two weeks ago, the Cobden report is predicting a recession occurring in the next eighteen months. Central bankers are aware that the business cycle is suggesting that a downturn will happen over the next few years; their problem is that they are not sure that they have the right financial tools to counteract the effects of this.

Now all the major economies around the world are growing, something that has not happened for some time, unemployment is falling quickly and business activity is increasing beyond the pre-crisis levels. This creates upward pressure on salaries and uses up any slack in the productive economy which normally causes inflation to rise. This is not happening and nobody is entirely sure why this is the case. In fact, it is not just inflation that is the problem, salaries are not rising any more than 2% roughly in line with the average. That is two indicators not behaving as they should which is an enigma for economists.

It is generally accepted that some inflation is good (2% is the norm currently) since it gradually devalues debt over time and in a thriving economy salaries will rise above the rate of inflation making everyone better off. Economies eventually overheat and interest rates rise to calm things down but with interest rates so low and even in negative territory in some countries, this has a big impact on asset prices. In effect it reduces the value of bonds and other interest bearing securities causing a fall in capital value for investors. Since buying assets on margin to increase yield is a normal function these days this would cause many funds and people to incur substantial losses which may have serious consequences.

Since the bulk of lending is still done by banks, this could create another banking crisis which is of great concern for central bankers. In Europe and other countries many banks still have non-performing loans from the previous crisis which only compounds the problem. This is why the Cobden report believes the catalyst of the next recession will be in Europe and many other commentators think the same thing.

Therefore, the key indicators inflation, salaries and interest rates become extremely relevant in the decision making by central banks to keep the show on the road. At the moment, they are uncertain about what action they should take to prevent this scenario from occurring. This is a very brief overview of the central banking problem but you can see the difficulties they have to work out a solution. That is why this meeting of the IMF is particularly important for the people responsible to come up with a new theory to manage economies.

I confess I do not have a solution for this enigma but it clearly explains why some people are very concerned about the failure of the current model. Some of the ideas we have discussed in the previous weekly comments may encourage and stimulate new thinking but on their own they do not specifically address this particular problem. We will have to wait and see if anything original arises from the IMF meeting and eventually from the economic think tanks that work with them; I wish them good luck.

That’s all for this week, more observations next week.

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