Is inflation truly important?

YES, IT IS. IT IS SO ESPECIALLY in an economy where head-on CPI inflation is a lot higher than what it was, say, 17 years ago. Hence, a decade and a half of ‘inflation targeting’ didn’t end up anywhere near the target. It is also important for the advanced world, and they take it seriously there. Consider the reflation argument in the U.S.: Are U.S. fiscal and monetary policies conducive to high inflation, and if yes, would that be temporary, as the Fed now seems to advocate? Would the Fed’s current stance and the avenue it opens up cause a stir in the future? And yes, there have been monetary policy-induced cycles in the past in the U.S. also.


Let us put things on a historical balance sheet. In 1979, when the world was hit by the second oil shock, inflation was unbound and reached double-digits. Jimmy Carter appointed Paul Volcker to the Fed, and Volcker immediately hiked the interest rate and curbed all monetary aggregates- M1, M2 and M3. By November 1980, the FFR hit 17%. Carter lost to Reagan who left Volcker in charge. Volcker’s crusade continued under Reagan and in June 1981 the FFR peaked at 20%. The result was historically named the “Volcker deflation”, which initiated the “Great Disinflation” of the 1980s.

However, this wasn’t the end of the story. The “Volcker deflation” also triggered the worst recession ever since WWII at that time, when unemployment skyrocketed to 11%. Inflation was down to 4% and the USD/GBP (Dollar to Pound Sterling) rate was almost at par for some years. The American Friends of the LSE (London School of Economics) date back to that episode. In an unusual move, many American students had preferred top British schools because the dollar was so overvalued that tuition expenses in the UK were much lower. The USD depreciated only after the G-3 intervention at Plaza in 1985. Volcker stepped down in August 1987, two months before “Black Monday”.


Ray Parkes (Yale) conjectured more than 15 years ago that the reason for the drastic rise in multiples (basically PE, the price-earnings ratio) was a direct consequence of foreign capital inflows into U.S. equities. The period would be reminiscent of 1981-1985, when the dollar appreciated to such an extent that it was on par with the Pound Sterling. It took the Plaza Accord of 1985 to end this episode. At that time, the reason for dollar appreciation was flows to American Treasury bills because of the interest rate differential. American fixed income had become very attractive compared to the Deutsche Mark, Sterling and other major currencies in the aftermath of the Volcker deflation. Indeed, in June 1980 the FFR had hit 20%, the peak level in a century. Exuberance isn’t uncommon.


The story was different in the late 1990s. Back then, there was talk about the “new economy”, America conquering both inflation and the business cycle. So, it could become a ‘soft power’ at last. The real economy repercussions were also astonishing since the unemployment rate, to pick a key variable, had fallen to below 4% in 2000. After all generations of economists had relentlessly emphasized the idea that the ‘natural rate of unemployment’ – NAIRU, or Non-Accelerating Inflation Rate of Unemployment – was 6%. It couldn’t be expected to fall below this level. It happened though. Is this time any different? Are there reasons for fundamentals-backed multiple expansions? I doubt it very much. Bubble or not, exuberance was nonetheless present back then.

Today, the story is once again entirely different. There is the COVID-19 breakout, and governments in advanced economies believe they should do whatever they can to shore up both household and business demand. They spend a lot of fiscal money, and pursue a loose monetary policy. These are policies that eventually end up with high inflation. The questions are: when and for how long? The danger of looking down the danger of inflation is unwarranted even under the current conditions of extreme duress.


Hélène Rey (London Business School) suggested that the Trilemma is in fact a Dilemma. Whether or not the Fed’s monetary policy spillovers have a bearing on EM monetary policies depends on whether they are open or not to financial flows, in proportion to the degree of their openness. This is even stronger an argument than the Mundell-Fleming Trilemma. A small open economy – this is a technical term, it doesn’t mean that the economy is actually small, just that it can’t change world prices and takes them as a given – with a heavy FX debt and a large current account deficit is liable to bear the impact of Fed policy change spillovers. The only way it can benefit from the adverse general impact – the size of cross-border capital flows to EMs will be smaller due to both the Fed interest rate hikes and the downsizing of the Fed balance sheet – is a flawless record of internationally cooperative monetary policy, central bank independence, rule of law, sound ‘doing business’ conditions, and suchlike. The share a specific country attracts from a shrinking pie can actually thus increase. But this is only a theoretical possibility. If a central bank doesn’t care much about rampant inflation, or gives that impression, or unilaterally sells precious reserves without getting any tangible result, and so on, benefitting from that theoretical possibility becomes impossible even with relatively high interest rates. The Trilemma Mark 2 tells us the exchange rate risk can’t easily be reduced to acceptable levels.


If the currency risk goes up (a) but there isn’t one single risk factor that stands alone – suppose cross-border flows, geopolitical risks, foreign trade risks, the obvious failure of your growth strategy, if any, etc.; (b) and the risk is endogenous – dollarization, FX-denominated domestic debt issuance, over-reliance on imports so you can produce and export, a very closely knit co-variance matrix across the goods market domestically, and suchlike; (c) but the currency fluctuation isn’t one-shot, it is continual; then the intervention will end up a failure. That much is obvious, and isn’t subject to debate. It is economics at its best. In fact, even multinational efforts to regulate either currency or commodity markets with the help of the IMF or under the auspices of UNCTAD as it happened in the 1970s didn’t end up well, most of the time.


The intertemporal approach goes beyond the Mundell-Fleming model, and as Maurice Obstfeld has put it, it gives us a tool for thinking about the interplay of external balance, external sustainability, and the equilibrium real exchange rate. Any approach that fails to take into account capital gains and losses on the net foreign asset position, i.e. valuation effects, would necessarily be misleading in a world of instantaneous financial capital flows. The currently huge gross cross-holdings of foreign assets and liabilities make sure that asset price movements largely affect highly leveraged country portfolios. Balance of payments reports the current account at historical cost, and the same consideration applies to the national income accounts. Nevertheless, for countries that either issue huge chunks of debt in foreign currencies, or for countries that hold large amounts of assets in foreign currencies – China and Japan are now good cases in point – it is imperative to take into account valuation effects.


Turkey more or less falls in this category. This isn’t because of its large foreign asset holdings, but because of its large FX-denominated debt. Furthermore, the standard inter-temporal approach not only overlooks the financial adjustment channel and focuses solely on the traditional trade adjustment channel it also by the same token downplays the role of risky investments and that of adjustment costs. Therefore, the terms of trade only show that net exports may or may not contribute to growth in the long-run. The balance of payments per se only provides an account of how international competitiveness unfolds. The current account only showcases the amount of FX-needs on a monthly basis. The financial account, including valuation effects, determines the final verdict. And the financial account in turn is determined by both global risk appetite and sound monetary policy at home.

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