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Inflated Obsession

TheWall Street Journal

These are hardly marginal voices. What’s more, they are verbalizing what many central bankers fear, and that is the problem. Inflation worries are wired into the collective psyche of the banking profession--and into the fiber of the institutions that guide western economies. Central banks were designed to guard against inflation even in the face of angry public opinion that viewed higher interest rates not as a tonic but a punitive tax on their hard-earned wages. Given the legacy of the 19th and 20th centuries--with regular periods of hyperinflation arriving like the plague to sweep away gains and threaten social stability, fear of inflation is understandable. Unfortunately, it is very likely misplaced and misguided. The levers of interest rates and money supply may have worked for inflation of the 20th century but will be blunt and ineffective as tools in the 21st.

So what’s changed? The globalization of capital and money supply has undermined the ability of central banks to set market interest rates. Measuring money supply nationally was challenging enough in the past, but today there is no way to measure global money supply. It hardly stays in place long enough, and reporting standards aren’t uniform. What’s more, the crisis of 2008-2009 exposed the degree to which no central government is in full control of its national economy--and indeed, there is reason to question whether the very idea of a national economy makes sense in a world where capital and goods circulate the way that they do. For years, until last fall that is, the Fed raised rates and lowered rates from 1 percent to more than 5 percent, yet the rate of the 10-year Treasury stayed at an average of 4 percent. Why? Because the global market was determining rates, not the Fed.

The larger concern is that central banks will utilize archaic tools against the wrong threat--not a good combination. If you are prepped to fight inflation and spend gobs of energy looking for it, you’re likely to see mirages if not the real thing. Then you’ll start trying to prevent what you think you’re seeing. It’s a bit like having a large, well-armed military: It exists to fight conventional threats, and it’s difficult not to avoid using it.

But while central banks and orthodox economists are revving up for the coming threat of inflation, how can there be goods inflation in a world where wages have topped out in the developed world and any growth will come from the developing world where wages are still a tenth of what they are in Europe and the U.S.? In short, the price of finished goods can only rise if consumers can pay for them. Companies can’t just raise prices because they want to--they always want to. They can only raise prices if people are willing and able to pay higher prices Today, however, no company, with the exception of unique brands like Apple, can pass on costs to consumers, because there is no consumer base that can support higher costs. That hungry Chinese market or the growing market of India and Brazil is there, but only at a lower price point: Hence the success of Wal-Mart in China and Tata’s $2,500 car in India.

Many economists retort that what matters is the “money supply.” If there are too many dollars in the system--and with the recent actions by the U.S Fed, there are indeed more dollars--that is supposed to trigger inflation. When the U.S. economy (or any economy for that matter) was a closed system with firm controls on the flow of capital in and out of the country, the connection between excess money and inflation may have been true. But with the porous capital accounts and flexible exchange rates of today’s world, money supply is being absorbed globally and circulated in novel ways that change the equation.

Then there is the problem of anecdotal evidence. Many people find the notion of arguing that inflation may not be a problem offensive. At an individual level, inflation is a catch-all for not being able to afford whatever one needs or wants to buy. In addition, while there has been almost no evidence of goods inflation for the past years--the Consumer Price Index has stayed at about 2 percent and now is much less--there has certainly been food and fuel inflation well into 2008. But rising fuel costs aren’t the same systemic issues that rising goods costs are, because as fuel goes up, consumption tends to go down and efficiency increases. In essence, fuel costs are both volatile and distinct, as is the price of agricultural commodities. They certainly impact individual balance sheets, often negatively--or during the first few months of the year, when prices were falling, positively. That isn’t the same as widespread goods inflation, which is what sets off alarms for economists and policy makers.

Yet, as most investment advisers will tell you, most “average” people tend to believe that inflation has been rampant. That’s because wages in the United States have barely budged in years even as desires (not to mention health care costs) have increased. That helped fuel both the mortgage crisis and a widespread feeling that life isn’t affordable because inflation is placing too many of life’s necessities (desires) out of reach. The fact that everything from cell phones to televisions to cars has become cheaper isn’t experienced with the same visceral intensity as the fact that incomes are usually not enough to cover both core needs and natural but not essential desires. Saying that inflation isn’t an issue is like a slap in the face, and people tend to reject the proposition angrily.

But the fact remains that, overall, no matter how you calculate it, finished consumer goods aren’t increasing in price, and given that those constitute a large percentage of spending, that means that there is no discernible inflation. The current rate of core inflation in the United States is 1.8 percent, and it has been in the vicinity of 2 percent for years. With home prices now descending as well, and interest rates on the lower end of multi-year averages, even affording a home is easier--if anyone had the confidence or credit to buy one. Inflation rates in Europe, the United States, Japan, and elsewhere are zero or even negative, while even in “hot” economies like China and Brazil, there is no indication of runaway prices. Yet central bankers, politicians, and consumers keep looking, convinced that it’s there, hiding in plain sight. And if rates do move up a bit (as they have recently), or if prices start rising modestly after a year of rising not at all, there’s a real risk that those moves will be taken as proof that the inflation monster is awakening from its slumber. That will tempt policy responses meant to contain it. The Fed and other central banks will raise interest rates; investors will allocate money so as to avoid the perceived risks of inflation eroding returns; valuations of stocks may well go down, as they often do when inflation is seen as on the rise, as will stock prices (which has been happening in the past month); and governments will seek to reduce deficits. All of these steps will have the effect of choking off growth and activity.

That said, there are some signs of greater openness to the new. The two major players of the global economy have been nimble and creative, with more willingness on the part of the Obama administration and the Chinese government to allow for the possibility that the future may not look much like the past and that policy responses will have to be innovative. The June visit of Treasury Secretary Geithner to China emphasized the awareness that the Chinese and U.S. economies are intimately connected, but the next step would be to recognize that variables like inflation and rates need to be part of the future dialogue between central bankers, and not simply looked at by each central bank on its own.

Let’s hope that the spirit of openness to the new prevails. The alternative is the triumph of old wisdom, anachronistic thinking, and outmoded responses, all of which will ensure that future will indeed look like the past, and in all the worst ways.

Zachary Karabell is the author of the forthcoming Superfusion: How China and American Became One Economy and Why the World’s Prosperity Depends on It. He blogs at

By Zachary Karabell