A Chance to Recover While the Inflation Dragon Is Subdued?

By Smith, David | Management Today, December 1993 | Go to article overview

A Chance to Recover While the Inflation Dragon Is Subdued?


Smith, David, Management Today


Inflation, as everyone knows, is never beaten. Rather, it can be subdued for a while before it regroups and comes back with a vengeance. This has been the pattern of recent years. In the mid- 1980s, for example, the collapse in world oil prices led everyone to believe the inflation dragon had been slain. But a couple of years later, and particularly in Britain, it was back, in virulent, fire-breathing form.

I write that by way of a caveat. The difficulty with the 'keep vigilant at all times' argument about inflation is one of degree. Does it mean, for example, that base rates in Britain should never have been reduced from their 15% level of the 1980s -- because of the danger that inflation would come back to haunt us. Of course not. Therefore, when finance ministers and central bankers say that to relax policy would risk higher inflation, they are not talking absolutes. Rather, they are saying that they know best. Often as we have seen in recent years, they do not.

The question is a particularly relevant one at present. Oil prices have not collapsed, as they did a few years ago, but they are weak and the Organisation of Petroleum Exporting Countries (OPEC) is struggling with the problem of how to accommodate extra production from Iraq next year without provoking a renewed fall in prices. Other raw materials, similarly, are either falling in price or, at the very least, are no better than stagnant. Industrial raw material prices are down on the levels of a year ago, in large part reflecting the weak world recovery.

At the same time the decelerating growth in world money supply has continued. To any monetarist, this means that inflation will remain low, not just for now but for some time ahead, at a time when growth will remain distinctly unexciting. As the chart shows, the 1990-3 period has been one of weak growth in the industrialised countries of the OECD (the Organisation for Economic Cooperation and Development) whose members comprise OPEC's customers. This has been partly offset by strong growth in the economies of East Asia, excluding recession-hit Japan.

This period of slow growth or recession for the OECD economies has produced a significant output gap, the difference between actual and potential (or trend) output, as is evidenced in high levels of unemployment and spare capacity throughout the world. Even with a robust recovery, therefore, it would take two or three years before this gap was made up. The weak recovery that is in prospect means that the gap will persist for longer than that, keeping down inflation.

In Britain, the Treasury's fear is that the labour market leopard has not really changed its spots and that even a reasonable recovery will see a significant acceleration in annual pay increases. …

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