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That old stagflation dilemma again Samuel Brittan Financial Times 07/12/07 There is not all that much difficulty in steering a modern economy when it is faced with one main danger. If that is inflation, the need is clearly to rein back on the growth of demand. If the central bank overdoes the restraint it is not all that difficult to correct its error by loosening its policy. If its first measures prove inadequate, it can step up the dose. Should the main danger be recession or a severe slowdown it will need to apply a stimulus, for instance by lowering the policy-determined short-term interest rate. A point may indeed be reached where monetary policy needs to be supplemented by fiscal policy, which is a posh way of describing lower taxes or higher public spending, in principle temporary. As long as policymakers do not delude themselves that they can achieve pinpoint accuracy and are not afraid of a little trial and error the task is not all that complicated, and outside analysts are kept in employment predicting their next move. What, however, should they do if the economy is faced with both increasing inflation and severe growth slowdown? This is the dilemma of stagflation. It was illustrated by the Bank of England’s recent judgment that the outlook for the UK economy in the near term was “one of slowing growth and rising inflation. But further ahead that outlook is for a return of growth to its average rate and inflation to the target.” You can believe the second part of the assertion or not. In any case the Bank, which was raising its “policy rate” as recently as last July, has now changed course and is following the Fed in applying a stimulus to counter the effects of the credit crunch on economic growth. The European Central Bank has, however, stood firm, admittedly at a level of both nominal and real interest rates considerably below the UK’s. So, far from the stagflation dilemma being a new problem, it is one that has recurred at least once every decade since the 1970s. But we are still far from a solution. The puncturing of the housing and property booms in so many countries, which in turn has generated a headline-scale credit crisis, points to an output slowdown and rising unemployment. Yet the sharp rise in oil and commodity prices, together with signs that the downward pressure on prices from cheap Chinese and other third world products is coming to an end, point to the danger of increasing inflation. A tentative answer to the dilemma was suggested by the Organisation for Economic Co-operation and Development in the 1970s and 1980s, known by the label of “non-accommodation”. The outside influences such as oil price increases were defined as “shocks”, to be absorbed in the price level. There should be no attempt to roll back other prices to offset the shocks. But policy should be strict enough to prevent these knock-on effects from feeding into inflationary expectations and generating a new wage-price spiral. The approach is inadequate in an age of inflation targets, where any sharp increase in prices is liable to be regarded as a breach of the targets and therefore a policy failure. There is, however, an alternative approach in keeping with an inflation target regime. This is to treat the inflation targets as long-term ones to be attained over an average of several years. Such indeed was the behaviour of prices in the heyday of the international gold standard. US wholesale prices, for instance, increased by an annual average of only 0.1 per cent from 1879 to 1913. Yet the variability of prices around this nearly flat trend was greater than that experienced in the inflationary decades following the collapse of Bretton Woods in 1973. In the UK the cost of living was highly stable from 1846 to 1914. Yet this long-term stability masked very sharp year-to-year movements. The cost of living fell by more than 12 per cent in 1846 and rose by a similar amount in 1853. In 1900, the last full year of Queen Victoria’s reign, prices rose by 8 per cent; and they fell by more than 2 per cent in 1908. These fluctuations provided a safety valve against short-term pressures; but the breadwinner could plan for his grandchildren or his business knowing that neither inflationary nor deflationary pressures would get out of hand and that his best bet was that the price level in 50 years’ time would be very little changed. The long-term stability of the late 19th century was not, of course, due to government measures but was the semi-automatic effect of the international gold standard. The inflation targets laid down by governments often have no time span over when they have to be achieved. The two-year horizon employed by the Bank of England reflects only its own interpretation. If inflation targets for half a century ahead were announced today they would understandably be disbelieved. Any shift of focus would have to be gradual in the absence of gold or any other anchor. Above all there would have to be periods of literally zero or even negative inflation to offset the upward shocks. The first job now is to convince people that monetary relaxations this winter in spite of rising inflation represent a tactical retreat and not the start of a headlong rout.
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