In the comment section to a previous post, I see a lot of misconceptions about inflation. One argument is that inflation is determined by global factors, and that global slack explains the current low rates of inflation. Slack doesn’t explain inflation, indeed the US had more slack in 1981 when inflation was 10% than it does today with 2% inflation. Inflation is determined by monetary policy.
I pointed to hyperinflationary Venezuela, but that doesn’t seem to convince anyone. So today I’ll look at more “normal” countries. While it is true that prices across countries are linked via the “law of one price”, this only tends to equalize inflation rates under a fixed exchange rate regime. Under floating rates, nominal prices can diverge as exchange rates diverge. Consider the UK and Switzerland, which have seen vastly different inflation rates since 1971:
Over the past 11 years, the UK has averaged 2.2% inflation, while Switzerland has had zero inflation. Over very long periods of time, this divergence is associated with a dramatic change in exchange rates:
Just before the Bretton Woods system ended in 1971, the Swiss franc was worth about 23.5 cents while the pound was worth about $2.40. Thus it took more than 10 SF to buy one pound. Today the SF is around a dollar and the pound is about $1.28. It seems very likely that the SF will eventually surpass the pound, due to Switzerland’s persistently low inflation rate. However, the exact date this will occur is difficult to predict, as purchasing power parity doesn’t work very well in the short run. Rather, PPP is most useful in explaining very long run changes in exchange rates.
Here’s the key point. Both Switzerland and the UK face the same price for imported wheat, copper, oil, and Toyotas. Both face periods of global slack followed by periods of global growth. So you can’t explain this divergence in inflation rates by pointing to global factors. Ironically, Switzerland has actually had unusually high inflation relative to the UK, when you account for changes in the exchange rate. If PPP held perfectly, then Swiss inflation would have fallen even further below the UK rate. Swiss inflation was a bit higher than predicted by PPP because during this period Switzerland became a very high cost place for non-traded goods, partly due to very high wage rates and property prices.
But the big story is monetary policy. Swiss inflation has been far lower than UK inflation for one simple reason. They’ve run a tighter monetary policy. Global factors do not determine inflation.
If there were a global recession and central banks foolishly followed Keynesian policies of targeting interest rates, then it’s quite possible that almost all countries would see a temporary dip in inflation, rather than the sort of increase that is appropriate during a recession. But that’s not because global factors are determining inflation in any technical sense, rather it’s because many central banks make the same sort of mistakes. (Israel and Iceland are exceptions, they are smart and have pushed inflation higher during recent recessions.) But even when changes in inflation rates are correlated across countries, the trend inflation rates still vary, depending on local monetary policies. Switzerland will likely have lower inflation than the UK during the next global recession, because it has tighter money.
READER COMMENTS
Michael Sandifer
Mar 3 2019 at 3:12pm
Scott,
I have to disagree a bit. I see changes in liquid asset markets in the US in response to some overseas events that exceed those explainable by direct trading relationships. I think that, for example, when Euro area crises flare up, overseas demand for dollars increases, at the very least treating the dollar as a safe haven. This drives US equity markets and often interest rates down, as there’s uncertainty as to whether, if the Euro crises continue or worsen, the Fed will expand the money supply to compensate.
Michael Sandifer
Mar 3 2019 at 3:14pm
Of course, in my example above, the Fed is still 100% in control of US NGDP. That’s why I only disagree a bit.
Scott Sumner
Mar 3 2019 at 10:45pm
Michael, It seems to me that you are agreeing with me.
Michael Sandifer
Mar 3 2019 at 3:21pm
I have a feeling that one day we may have some kind of automatic monetary policy that adjusts the money supply daily in response to daily seaonalized transaction data.
Benjamin Cole
Mar 3 2019 at 8:01pm
Okay, we keep saying the US economy is globalized in terms of capital markets, products and services, even labor flows. Money flows across borders as easily as water down the Mississippi.
If that is the case, then do not the actions of major central banks have global effects? Are all of these international effects of central-bank actions negated by exchange rates?
Also, if there is a continual and rising tide of less-expensive imported goods, would that not be reflected in inflation as measured in the receiving nation?
In terms of inflation, are all these effects of central-bank actions negated by exchange rates?
Scott Sumner
Mar 3 2019 at 10:44pm
Ben, You missed the point of the post.
S D
Mar 4 2019 at 3:17am
Super post.
The euro area is about 70% of the EU labour market. Pre-2008, the unemployment in both the euro area and the broader EU was about the same.
During the crisis, and since, unemployment has been about a percentage point higher in the euro area: https://ec.europa.eu/eurostat/statistics-explained/index.php?title=File:Unemployment_rates_EU-28_EA-19_US_and_Japan_seasonally_adjusted_January_2000_January_2019.png
The reason: the ECB has run tighter monetary policy in the euro area than the central banks which are in the EU but outside the euro area, like the UK, Sweden and Poland.
There is no real plausible other explanation. The countries in question have relatively integrated labour markets, highly integrated product markets and are subject to the same global and social trends. Business cycles are well correlated.
The only thing that can cause a divergence like this is monetary policy.
Brian Donohue
Mar 4 2019 at 12:03pm
A quibble: massive increases in Chinese productivity have intensified capitalism’s inherently deflationary tendencies this century, producing lower inflation than we would otherwise have seen. In other words, central banks need to run “looser” monetary policies to generate inflation than they used to. Not sure how long it lasts.
Jonathan Wilmot
Mar 7 2019 at 10:38am
A neat and concise polemic that makes some good points sometimes forgotten. But there are a few buts…
Yes of course, very badly governed countries can and often do experience hyper-inflation – even in a low inflation world. But is that hyper-inflation “caused” by monetary policy?
Under floating exchange rates, individual central banks can of course determine their home country inflation rate – standard theory. But perhaps it’s more interesting and accurate to say that in practice the central bank sets the level of inflation RELATIVE to a global norm – thereby driving (long-run) currency trends. (Though there may also be other factors which drive long-trends in real exchange rates – cf Krugman 1976)
Perhaps you would just scoff at the idea of a global “norm” for inflation but it seems odd to (implicitly) deny that there have been secular periods of rising or falling inflation shared across most major economies. Once you accept that, it’s not so stupid to think that the absolute level of home country inflation might not be fully determined by the home central bank.
On “slack”: measures of the global output gap in manufacturing are correlated with US goods price inflation, especially durable goods price inflation. That link appears to be (much) more significant, than the link between broader measures of US slack (UR, GDP based output gap) and broader measures of inflation like core PCE. So global slack could influence the composition of US inflation, even if slack (domestic or foreign) doesn’t – strictly speaking- set the level of overall inflation.
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