Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 4 Monetary Policy and Inflation

Global Inflation Experience

Sustained inflation is a relatively modern phenomenon (IMF, 1996). The international experience until World War II was one of long run stability in prices, with periods of inflation - generally war induced - getting offset by periods of deflation. Average inflation was lower in the first half of the 20th century than that in the second half of the century. At the same time, this pattern of increasing prices followed by declining prices rendered inflation more volatile in the period before the World War II vis-à-vis the post-War period. Following disturbances in the inter-war period and due to factors like changes in macroeconomic policies and varying degrees of supply shocks, the world experienced rising price levels from the late 1960s. Before the 1970s, the gold-dollar nominal anchor of the Bretton Woods system acted as a constraint on accommodative policies as long as the US maintained low inflation, because of other countries commitment to maintain the exchange value of their currency. In the post-Bretton Woods era, however, the freedom to pursue independent monetary policy emerged as a key factor contributing to high inflation during the 1970s.

Since the late 1960s, expansionary fiscal policies and accommodative monetary policies contributed to a strong cyclical upswing in the global economy creating supply-demand imbalances in many non-fuel primary commodities. In the US, for instance, the Vietnam war and tax cuts expanded the fiscal deficit. Fiscal deficits in advanced economies expanded from 1.2 per cent of GDP during the 1960s to 3.4 per cent during the 1970s. Capacity constraints were already putting upward pressure on wages and prices and as the oil price shock hit in 1973, many countries pursued accommodative monetary policies to offset the adverse output and employment effects of the shock. Consequently, inflation surged to double digits in many countries including the US, the UK and Japan. In response, monetary policies were tightened but inflation persisted - the period of the 1970s has come to be called the 'Great Inflation'.

A number of factors contributed to the surge in inflation. In addition to supply shocks, the high inflation in the 1970s is believed to have been due to lax monetary policies. Although nominal interest rates were raised, it appears that they did not keep pace with the rise in inflation rates. As a result, despite increases in short-term nominal interest rates, real interest rates declined. Estimates of monetary policy reaction functions like the Taylor rule that relate short-term policy rate to inflation and output show that the coefficient on the inflation rates was less than unity for the period prior to the 1980s. Falling real interest rates during the 1970s provided a further boost to aggregate demand and, in turn, this kept inflation high. One reason as to why monetary authorities were accommodative during the 1970s could perhaps be attributed to the belief that there existed a long-run trade-off between inflation and output, i.e., monetary policy makers could achieve permanently lower unemployment by accepting a little more inflation (Box IV-I). Initially,the trade-off argument appeared to be holding true as unemployment fell and inflation rose only moderately during the later part of the 1960s. However, the developments during the 1970s showed no such trade-off and the actual outcome was stagflation - high inflation and high unemployment - validating the Friedman-Phelps critique which stressed no exploitable long-run trade-off. Although a consensus has emerged on the basis of empirical evidence that in the long run there is no trade-off between employment and inflation, it is the inconclusive evidence in the short-run that poses a challenge for monetary management.

More recently, the view that central banks made a deliberate attempt to exploit the inflation-output trade-off during the 1970s has been subjected to a critical analysis. It has been argued that inflation increased during the 1970s because policymakers overestimated the degree of productive potential in the economy. Overestimation of potential gross domestic product (GDP) prompted policymakers to provide excessive monetary stimulus resulting in the "Great Inflation". The misplaced belief in the potential efficacy of wage-price controls also played a key role. The monetary policy neglect hypothesis - monetary policy was not seen as essential for inflation control and the job was delegated to income policies (wage and price controls) - led to a combination of easy monetary policy and use of other means to control inflation resulting in the breakout of inflation in the 1960s and 1970s. A centralised wage bargaining and indexation system left most of the countries with higher inflationary expectations (IMF, op cit.). These alternative hypotheses notwithstanding, the primary cause of the "Great Inflation" was over-expansionary monetary and fiscal policies beginning in the mid-1960s and continuing, in fits and starts, well into the 1970s.

In contrast to the mainstream view which stresses oil shocks as one of the factors contributing to high inflation during the 1970s, Barsky and Kilian (2004) argue that oil price increases and, for that matter, increases in other commodity prices as well during the 1970s were the effect of expansionary monetary policies being followed at that time. Monetary fluctuations help to explain the historical movements of the prices of oil and other commodities including the surge in the prices of industrial commodities that preceded the 1973-74 oil price hike. In this view, major oil price increases were not as essential a part of the causal mechanism that generated the stagflation of the 1970s as is often thought. The causality is thus not from oil shocks to inflation but from macroeconomic variables to oil prices. Strong economic expansions strengthen cartels such as oil cartels while recessions weaken them.

The high and erratic inflation of the 1970s was also associated with periods of exceptionally poor economic performance in terms of marked instability in output and employment in the industrial countries.

Recurrence of high inflation and the cumulative worsening of government finances brought into sharp focus both, the limitations of fiscal activism and the heavy costs of monetary instability. Therefore, central banks in advanced economies - notably, the US - resorted to deliberate disinflation measures. Monetary policies were tightened from the late 1970s onwards to rein in inflation and inflationary expectations.

Strong contractionary measures led to a global recession but subsequently inflation was brought down. Reduction in inflation was thus not painless and the transition to low inflation involved substantial costs in terms of output and employment losses (Ball, 1994). Countries such as Germany, Switzerland and, to a certain extent, Japan which had responded earlier to control inflation following the first oil shock, were relatively better off; although they could not escape the global downturn, macroeconomic consequences of the second oil shock were less severe. Inflation in advanced economies fell from an average of 9.3 per cent per annum in the second half of the 1970s and 8.2 per cent in the first half of the 1980s to 3.6 per cent in the second half of the 1980s. The decline was facilitated by a significant easing in oil prices, setting the stage for broad-based economic recovery.

Inflation moderated further in advanced economies during the 1990s. In contrast to the behaviour during the 1970s, estimates of Taylor rules show that the coefficient on inflation has exceeded unity in the period since early 1980s, i.e., in response to inflation threats, short-term nominal interest rates increased more than the increase in the inflation rate. Thus, real interest rates rose as inflation tended to go up which enabled a contractionary pull on aggregate demand and helped to contain inflation. A key factor that has contributed to low and stable inflation during the 1990s has been the institutional changes in the conduct of monetary policy - independent central banks, increased transparency and greater accountability - which has enhanced the reputation of monetary authorities and increased public credibility in their ability to deliver low inflation. Supporting economic policies - fiscal consolidation and structural reforms in the labour and product markets - also helped attain price stability. Efforts towards fiscal consolidation have been strengthened with clear-cut fiscal rules such as the Maastricht Treaty and the Stability and Growth Pact in the Euro area (see Module: 2).

Globalisation is also believed to have contributed to low and stable inflation. Lower trade barriers, deregulation, increased innovation and greater competition induced by the forces of globalisation have contributed to growth in cross-border trade exceeding that in output. Production of tradable goods has expanded rapidly and domestic economies are, therefore, increasingly exposed to the rigours of international competition and comparative advantage. This reduces unwarranted price mark-ups. Competition among countries to attract and retain mobile production factors also forces governments to reduce inefficiencies, ensure fiscal discipline as well as macroeconomic stability. The focus on macroeconomic stability is one of the factors that has led to greater central bank independence and, in turn, lower inflation. Greater competition in the economy makes prices more flexible which reduces the impact of unanticipated inflation on output. This lowers the incentive for the monetary authority to systematically raise output above the potential. At the same time, there may be limits to globalisation and the speed of innovation since it is not apparent that globalisation will continue to progress at the same pace as seen in recent decades. Accordingly, as Fed Chairman Greenspan (2004) has recently observed, the structure of the transitional paradigm is necessarily sketchy as "we have not experienced a sufficient number of economic turning points to judge the causal linkages among increased globalisation, improved monetary policy, significant disinflation and greater economic stability".

Low and stable inflation has also been attributed to technological advances in architecture and engineering as well as development of lighter but stronger materials. These technological advances have resulted in "downsized" output, evident in the huge expansion of the money value of output and trade but not in tonnage. As a consequence, material intensity of production has declined reflecting, "the substitution, in effect, of ideas for physical matter in the creation of economic value". This has contributed to the secular decline in commodity prices, notwithstanding short spells of spikes in these prices. Concerns over increasing commodity price volatility around this declining trend have, however, increasingly engaged monetary policy attention in the short-run. Declining share of commodity prices in final goods prices has been one important reason as to why consumer prices in most countries did not witness any sharp rise in 2003-04 even as commodity prices increased sharply during the period. The increase in commodity prices was reflected mainly in producer prices.

It is important to note that this moderation in inflation has not come at the cost of output volatility. Rather, the evidence suggests that output volatility has declined in the major advanced economies. For example, the standard deviation of growth rate of GDP in the US during 1984-2002 was two-thirds of that during 1960-83. Relatively stable GDP growth in recent decades is attributed to a number of factors such as more effective monetary policy, the increasing share of services in GDP, better inventory management and improved consumption-smoothing on account of financial innovations and deregulation. Good luck -absence of major supply disruptions and other such macroeconomic shocks in the recent decades - is also considered as one of the contributory factors. According to estimates by Stock and Watson (2002) for the US economy, almost 20-30 per cent of reduction in output volatility can be attributed to improved policy, another 20-30 per cent is on account of 'identified' good luck in the form of productivity and commodity price shocks while the remaining part - a substantial 40-60 per cent - is due to 'unknown' forms of good luck (the regression residuals).

Following the recent global slowdown of 2000-03, the fall in aggregate demand in the advanced economies put further downward pressures on the already low inflation. Illustratively, core inflation fell to less than one per cent in the US during 2003. Coupled with the ongoing protracted deflation in Japan at that time and deflation in a few other economies such as China, this raised serious concerns about a generalised deflation. Deflation in China - 'good' deflation - was largely the result of a fast growth on the supply side. Policy concerns mainly arise from deflation that emanates from inadequate aggregate demand. In this case, expectations of falling prices encourage agents to defer purchases, thereby discouraging growth. Deflation does more macroeconomic damage than an equal and opposite amount of inflation and monetary policy may turn ineffective at very low inflation rates. These concerns with deflation arise, primarily on account of the zero bound on nominal interest rates which constrains the ability of monetary policy to pursue an accommodative stance (Box IV.2).

An issue of debate in the context of global disinflation during the 1990s has been the role of China. In view of a sharp rise in its exports coupled with, at least till last year, a deflationary movement in its domestic prices, a view has gained that China has been a source of downward pressure on global prices. Estimates by Kamin, Marazzi and Schindler (2004) suggest that the impact of Chinese exports on global inflation has been fairly modest. China's exports could have reduced-

1. global inflation by 30 basis points (bp) per annum;

2. US import price inflation by 80 bp but, in view of the US being a relatively closed economy, the impact on producer and consumer prices has likely been quite small; and,

3. import unit values inflation by 10-25 basis points in the OECD countries.

However, these estimates should be treated as upper bounds since they ignore the fact that China's rapid export growth has also been associated with equally rapid import growth and China is, therefore, contributing to not only global supply but also to global demand. This has been vividly reflected in the sharp rise in global commodity prices beginning early 2003.