How big a threat are rising prices?

by R.A. | WASHINGTON

IN 2007 and 2008, before the world was swept by financial panic, the biggest global economic threat appeared to be a sharp and sustained rise in commodity prices. Soaring oil costs rattled rich world consumers while a spike in food prices battered the world's poor. Prices tumbled during the crisis but have crept up again in recovery. A new crisis may loom. Overheating emerging markets are boosting global demand at a time when supply is tight. Extreme weather events have led to poor harvests around the world. Some credit rising prices with a wave of political unrest, which has itself placed upward pressure on commodities, especially oil.

This week, The Economist argues that some inflation concerns are overblown. Accelerating inflation is unlikely in weak developed economies, and emerging markets have plenty of tools available to fight rising prices. But the frequency with which commodity price spikes now seem to occur is worrying. And so this week, we asked members of the Economics by invitation network to discuss commodity inflation and talk about how central banks should respond.

Their responses indicate that there are no easy choices. Eswar Prasad writes that in the short term central banks should ignore volatile food price moves and in the long term structural supply increases are necessary, but:

This clear-cut answer is clearly not politically tenable in emerging market economies. Moreover, it turns out that the traditional analytical answer is overturned when one accounts for key features of emerging markets. A substantial fraction of households in emerging markets do not have access to formal finance, and they spend a major share of their household expenditures on food (and fuel). Hence, changes in food and fuel prices have substantial effects on the consumption decisions of these households. Since expenditure on food in total household expenditure is high, and demand for food is relatively inelastic, households in these economies factor in food price inflation while bargaining over wages. Through this channel, food price inflation may feed into inflation expectations. Thus, in emerging markets even inflation expectation-targeting central banks have to be concerned about food price inflation. As my recent research with Rahul Anand shows, central banks can stabilise the business cycle and improve average levels of economic welfare by targeting headline CPI inflation rather than core CPI inflation...

Jahangir Aziz agrees:

It is nearly impossible, especially in emerging markets, to ascertain when food inflation has crept into inflationary expectations and into generalised inflation before it is too late. Unless one is certain that the supply shock is truly temporary, it is better to be preemptive with policy tightening. True, this won’t relieve food inflation, but unfortunately curbing demand for other goods that are interest sensitive is the only real option. To safeguard medium-term growth, inflationary expectations need to be kept under control, and that means sacrificing near-term growth. The only choice is whether to sacrifice a little now or a lot later.

Meanwhile, Richard Koo suggests that authorities should keep an eye on financial impacts on prices, and John Makin says it's difficult to imagine that inflation is less destabilising than currency appreciation (in countries where appreciations are being delayed).

As always, I encourage you to read the responses in full. There are obviously some idiosyncratic factors supporting current price increases, but the broader trends are clear. Emerging market growth is likely to continue putting pressure on commodity supplies, and those supplies will increasingly be subject to disruption thanks to extreme weather events (and, relatedly, to political unrest and policy reactions). Central banks must begin thinking about how to negotiate these crises in a manner than minimises economic and human costs.