1 December 2009
Vanessa Rossi
(Former Chatham House Expert)


November consumer price data for the US and Europe finally showed an end to months of deflation, as year-on-year consumer inflation rates returned to positive territory for the first time in months. The headline inflation rate might even surge to 2% or more by the end of the year although this swing will be largely due to base year effects - that is, current price levels are being compared to their late-2008 levels which dropped sharply after the Lehman crisis.

Not only might this fuel the debate over exit strategies from the recession but it will also fuel market concerns about inflation and the chances of central banks raising interest rates.

In reality, prevailing economic conditions hardly threaten to support high rates of consumer price inflation. All the major economies are running considerably under capacity and will remain so well into 2010 as global demand struggles to pick up. The surge in unemployment (which is expected to continue rising, peaking as late as 2011) has also damped down wage growth. And oil prices are unlikely to surge to new peaks given the still weak global demand.

More importantly, given the arguments raised about the effects of recently lax policies, government bailouts are unlikely to have an inflationary impact. For government intervention to be inflationary, it must outweigh the deflationary impact of wealth and income losses. In other words, 'net new money' is the key: how much new money is being created rather than being used to partially replace lost wealth?

The answer is not much. Global wealth losses from the crisis are calculated to be around $40-50 trillion, the bulk of it in the form of lost equity from stock markets, asset write-downs among financial institutions, and the fall in housing prices affecting households - most notably in the US. Income losses have also been substantial, including a decline in business revenue and investment of about 20-30% and a drop of $3-4 trillion in export earnings. In comparison, the cost of government interventions worldwide has been cited at around $20-25 trillion - a staggering figure yet clearly not in the same league.

Not only is this number far less than the loss in wealth and income, but only a fraction of this money (roughly 20%) has actually been spent, and hence could potentially feed inflation. The rest has been in the form of guarantees and pledges. For example, liquidity support (such as interventions in the repo and commercial paper markets) is constantly being rolled over and is also secured by collateral, ensuring some recovery of losses if there is no repayment.

Meanwhile, shares from nationalised banks and toxic assets purchased by central banks may recover some of their lost value once their markets revive - in fact, this was the main reason why the IMF recently improved its forecast for expected write-downs. And on the fiscal side, much of the support in the form of tax cuts is likely to be saved rather than spent at the same time that other forms of fiscal relief end up compensating lost expenditure.

In short, most government money has been pledged, rather than spent. And that which has been spent is likely to be recovered (at least partially) or otherwise used to make up for lost private wealth and spending.

Finally, the impact of cheap money and carry trade on asset prices should be identified as a different problem from wage and consumer price inflation. Furthermore, market bubbles should be tackled in ways mindful of the potentially damaging repercussions of heavy handed policy on the still fragile economic recovery. Confusing these different problems could be dangerous - policymakers need to tread carefully and lightly. Lax policy would have to be pursued for longer and on a larger scale to even begin to create consumer price inflation - an unlikely scenario - but, in contrast, rapid tightening and marked increases in market rates could well snuff out real growth prospects for 2010 and bring back the risk of deflation.

Further resources

Inflation - Ghost of the Past or Upcoming Threat?
Programme Paper, Vanessa Rossi and Rodrigo Delgado Aguilera, December 2009