Monday, June 23, 2008

Inflation psychology troubles central banks

Inflation psychology troubles central banks
Monday, June 23, 2008

FRANKFURT: In the view of a central banker, the worst thing about skyrocketing food and energy prices around the world is not that they are rising, but that more people believe they are here to stay.

Worries that a psychology of inflation not seen since the long run of sharply rising prices in the 1970s is taking root have become a common denominator of both the European Central Bank and the U.S. Federal Reserve, which are moving at their own speeds to cool expectations of higher prices.

The current bouts of higher inflation - 3.7 percent in the year through May in the euro area and 4.2 percent in the United States - are particularly dicey. If investors, companies and employees decide that these inflation rates will become more common, they will bid up prices, wages and interest rates for the day-to-day lending that lubricates all modern economies, now a serious threat in the view of worried central banks.

"They can't change current prices," said Jacques Cailloux, chief European economist at Royal Bank of Scotland in London. "What they are pretty convinced that they can do is dampen inflation expectations."

The ECB appears to be taking the lead in fighting this trend, and is likely to raise interest rates next week despite new reports Monday showing a further slowing in European growth prospects.

The Fed has also signaled it would consider raising rates after aggressively cutting borrowing costs as the U.S. economy headed into a sharp slump. But any reversal would be unlikely until later this year, analysts said, raising concerns about the Fed's efforts to keep the dollar from weakening further if the ECB got too far ahead in raising rates. A weak dollar fuels U.S. inflation, by raising the cost of imports. It spurs global inflation by raising the price of commodities priced in dollars, like oil.

For much of the past year, central banks have played a wait-and-see game, betting that higher commodity prices, particularly oil, would rise sharply without setting off price increases in related goods, or big demands for higher wages. In essence, they were hoping that the increases would nick bottom lines, but that the problem would end there.

That bet has not paid off.

Airlines have imposed fuel surcharges on tickets as oil assaulted the $140-a-barrel level. Companies that use crude oil as an raw material, like the giant multinational Dow Chemical, have raised prices, sometimes sharply.

In Europe, unions, riled by the impact of high fuel prices on members' pocketbooks, are asking for higher wages, a cost that could be passed on to consumers. Since unions are much stronger in Europe than in the United States, the trend distinguishes the ECB's task from that of the Fed, where a near-recessionary economy dominates worries.

Lufthansa's ground and cabin crews are demanding a 9.8 percent increase in wages, a decision that could ripple across other services industries. In Britain, though not a part of the euro area, 600,000 British local government workers voted Monday to strike over contract offers that do not reflect the rising cost of living.

Those decisions reflect what data on "inflation expectations" show, namely a rising perception that prices will increase more quickly in the future.

After the experience of the 1970s, in which inflation seemed to spin out of control, central banks searched for early-warning indicators that would signal when an inflationary psychology was taking hold. Economists responded with data designed to show what people were thinking about future inflation.

"The idea that inflation expectations driving actual inflation is very widely held by central bankers," said Julian Callow, chief European economist at Barclays Capital. "The problem is that it is hard to measure - you can only infer it from other sources."

One measure is the premium that bond investors demand to compensate for the risk of inflation over the life of the security. In Europe, markets have embedded an "inflation premium" in 10-year bonds, which has risen in recent months to 2.5 percent, according to Barclays, a sharp warning to a central bank whose goal is to keep inflation below 2 percent. It is also the highest level since the birth of the euro on Jan. 1, 1999, Barclays said.

Other surveys, of consumers and professional economic forecasters, have shown a similar rise, particularly over the past two months.

In the United States, the picture has been very similar, with bond market indicators edging notably higher. A survey closely watched by the Fed, a University of Michigan poll of consumers, showed inflation expectations in May rose to the highest level since February 1982, the last gasp of the great inflation of the 1970s.

That led to a sharp warning this month from the Fed chairman, Ben Bernanke. "The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations," Bernanke said on June 6. He added that the Fed officials "will strongly resist an erosion of longer-term inflation expectations."

The ECB president, Jean-Claude Trichet, only a day before Bernanke spoke, cited inflation expectations as the main reason why the bank would probably raise rates at its meeting July 3.

"We have to be credible in this delivery of price stability," Trichet said, "and that is the reason why we insist so strongly on inflationary expectations remaining well anchored."

This shift in focus - which is more pronounced at the ECB headquarters in Frankfurt than in Washington - has led economists to debate how far the central banks will raise interest rates to cool expectations of higher prices.

Trichet hinted at one rate increase, by a quarter percentage point, to 4.25 percent, in July. Other officials have since dampened speculation of a series of rate increases, and the ECB appears to be betting on a kind of psychological shock to financial markets - a slap in the face to warn of more if inflation expectations do not subside.

"What you want to do right now is short-circuit the transmission of these prices increases into future increases," said Cailloux the bank economist.

The shift in tone in Europe may already be having a U.S. impact, analysts said. With financial markets so tightly integrated, the expectations of higher inflation move quickly between Europe and the United States, especially because the current inflation shock, driven by oil and food prices, is a global event. That is pressuring the Fed to confront the issue, even though the U.S. economy is at or near recession.

"Bernanke and the core members of the Fed are being pulled along in this process," said Ethan Harris, chief U.S. economist with Lehman Brothers in New York. "I think they are reluctant to raise interest rates but it is hard with such hawkish rhetoric from the ECB and other Fed officials."

And rhetoric matters, no matter how far the ECB actually goes.

When Trichet talked about raising borrowing costs in early June he gave a fillip to the euro, already strong, since higher interest rates make euro-denominated investments more attractive. That pushed the dollar lower just as Bernanke and the U.S. Treasury secretary, Henry Paulson Jr., appeared to reverse the long-standing toleration of a weak dollar that had helped prop up U.S. exports.

A slowing U.S. economy can curb inflation as mounting job losses cut overall demand and limit companies' ability to raise prices. But if that does not cool inflation, the Fed will be in a bind.

"The Fed faces a serious dilemma," said Richard Berner, chief U.S. economist at Morgan Stanley.

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