Jun 17, 2008

If the global economy is slowing, why the inflation fears?

If the global economy is slowing, why the inflation fears?


Good question. Normally, a period of slowdown would be enough to take care of runaway prices, as constraints on labour, capital and resources ease. Evidence points to slower growth in world demand for these key economic elements, but in spite of this, commodity prices are stubbornly high. Producers are increasing selling prices in the face of weakening demand, just to remain viable. This is the essence of the new stagflation – and the prospect that it may spread more

generally to the rest of the economy, through wages and prices, is what worries central banks.


Has this generalized increase begun? At first glance, it might seem so. Consumer prices (CPI) are running well ahead of inflation targets in most countries. But the recent acceleration is very focused on food and energy price increases. Take these away, and core price growth is actually at, or in many cases below target.


For example, headline CPI is 4% in the US, but core is 2.3%. In the UK, headline CPI is 3%, but core is just 1.4%. Eurozone headline CPI is 3.3%, well above the comfort zone, but core growth is just 1.6%, well within its inflation target.


Canada faces similar conditions, and the situation in other key economies is roughly the same. At present, the data strongly suggest that the pass-through effect of higher food and energy prices has not occurred.


But that doesn't mean it won't. Today's data are important, but they don't give the whole picture. Future core price growth depends critically on expectations today, and if consumers and businesses alike believe that higher price growth is here to stay, they will gear their budgets to that new reality. That's what central banks fear, and because their actions take time to affect the economy, they have decided to send a signal aimed at reining in any change in expectations. And it is abundantly clear from past experience that failure to stem a nascent increase in inflationary expectations takes time and exacts a significant toll on the economy.

Source : Peter G. Hall, Vice-President and Chief Economist, Export Development Canada.

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