(At least) Three simple reasons to fear inflation

Tommaso Monacelli 20 March 2008



Inflation is rising throughout the world, with many blaming the Federal Reserve for its allegedly overly expansionary monetary policy. There are at least three arguments suggesting that the current inflationary surge is potentially dangerous: wage pressures, commodity prices, and the financial crisis. Invariably, central banks play a fundamental role due to their ability to influence the delicate relationship between current inflation and inflation expectations.

Wage pressure

When current inflation rises, it is of paramount importance that it does not trigger a demand for higher nominal wages, for this pushes firms’ marginal costs upward and ultimately generates more inflation. There is a vicious cycle: greater inflation today tends to be self-sustaining. Consider a union trying to re-negotiate a nominal wage contract for the next two years. Clearly, its strategy will be based on the expectations of inflation over that time horizon. Suppose that inflation is now at 3 percent, above the objective of 2 percent set by the central bank. If the union is confident that the central bank will do everything possible to bring inflation down to 2 percent in a reasonable time horizon, it will moderate its demand for a wage increase today. In other words, if the central bank is credible in setting its inflation target at 2 percent and is as transparent as possible about the transition path towards the 2 percent, unions and workers will perceive the 3 percent not as a failure but as a temporary deviation, and the central bank will be able to manage inflation expectations in the most efficient way. The key is to restrain any inflationary surge today, a lesson from past decades that most central banks worldwide should have by now fully internalized.

Commodity prices and expectations

Many claim that the strong rise in the price of food and raw materials (commodities in general) is one of the factors fuelling the current international surge in inflation. Why this euphoria in the price of commodities? There are at least two reasons, one structural and one cyclical. The first reason is a long-term one: an excess demand for raw materials (iron, zinc, copper, aluminium, etc.) originating from emerging market economies (China, India, Brazil). The second reason relates to monetary policy: Falling nominal interest rates (at least in the US) and rising inflation expectations push real interest rates downward. Indeed, in the US, real yields on Treasury bonds are negative as of today. Negative real returns, however, make holding commodities relatively more attractive. To understand this point, think about an extreme case. Suppose that the commodity is copper, and, for simplicity, that it is perfectly storable. If you buy 1 kg of copper today you will find yourself with exactly 1kg of copper tomorrow. What is the real return of such an investment? Zero! Yet this is still greater than the negative real yield offered by Treasury bonds. As a result, the demand for copper rises, bidding its price up. The more the Fed insists in lowering nominal interest rates, then, the more it may end up fuelling an overshooting in commodity prices.1 In this vein, we face the risk of another vicious cycle. If higher inflation today pushes inflation expectations upward, this will lower real yields, fuelling the demand for commodities, and therefore their price, even further. But this in turn is mechanically reflected in higher consumer price inflation. Once again, if inflationary expectations are not well anchored, an inflationary push today tends to be self-sustaining.

The financial crisis and the level of potential output.

In the plethora of comments on the effects of the current financial/credit shock, there seems to be a bit of confusion on its likely inflationary consequences. For instance, a commonly heard criticism to the ECB runs as follows: why worry so much about inflation? If indeed we are entering a recession, it will be the economic slowdown as such to ensure that inflationary pressures remain contained. Hence it would be preferable to do as much as possible to support the already weak growth in Europe. Seen from a different perspective: the financial shock we are facing is intrinsically deflationary.

This argument may prove fallacious, for at least two reasons. The first is well-known: not accepting a moderate slowdown today may induce an inflationary spiral that will require a radical change of direction of monetary policy in the future, with potentially very painful consequences for the real economy. To understand the second argument, it is necessary to recall the Phillips curve. According to this concept, current inflation depends on: (i) inflation expectations for the future; and (ii) the deviation of output from its potential level, i.e., the output gap. What is potential output? It is the level of output that an economy can achieve when prices and wages adjust in a perfectly flexible way to clear markets. Essentially, it is the level of output at which an economy tends to be on average. Potential output, however, is not immutable. It responds to structural changes in the degree of competitiveness of goods, labour and financial markets.

Both in the US and in the Euro Area, however, it is not yet clear whether the type of financial shock we are currently facing will ultimately have a negative impact on potential, rather than cyclical, output. In other words, it is uncertain whether this is a shock that may affect the degree of efficiency of our financial markets. If that were the case, that same shock may produce an upward, rather downward, pressure on the output gap. We would then be faced with an inflationary, rather than a deflationary shock, with the implication that this would require interest rates to rise rather than fall. Are European governments prepared for such a contractionary policy scenario?

It is instructive to recall the lesson of the 1970s. Then the fall in potential output was due to a slowdown in the rate of growth of productivity, which central banks largely failed to identify, leading to sometimes completely erroneous measurements of the level of potential output, and subsequently the effects of its changes on inflation. Today we may find ourselves once again faced with a similar problem, let alone the contemporaneous materializing, as then, of an oil shock. Yet another reason to avoid any complacency about inflation.


1 For an analysis of the link between real interest rates and commodity prices, see Jeffrey A. Frankel, “The Effect of Monetary Policy on Real Commodity Prices,” NBER WP 12713, December 2006 and his related work.



Topics:  Microeconomic regulation

Tags:  inflation, Central Banks, Commodity prices, financial crisis, wage pressure, expectations

Professor of Economics at Università Bocconi, Milan and CEPR Research Fellow


CEPR Policy Research