Ever since the financial crisis, there's been a debate bubbling away over whether policymakers need to be more concerned about inflation or deflation as a longer-term problem. The perceived need to avoid an outright depression has been the major driver of policy decisions up to this point. Inasmuch as the worst case has been avoided, this looks to have been the right choice. Of course, we can never test the counter-factual of what would have happened if Keynesian fiscal stimulus and quantitative easing had not been adopted, but I suspect there are few outside the Tea Party who would have wanted to take the chance of finding out.
The policy choices are not about to get any easier. The recovery in the developed world is still far from self-sustaining, but signs of inflationary pressures are steadily mounting. Global commodity prices have been on a tear; commodity-based currencies such as the Aussie and Canadian dollars are strong; and some domestic inflation rates are starting to look uncomfortable. In the UK, for example, CPI in November stood 3.3% above its year-earlier level. With VAT set to rise in January, prospects for CPI to fall back to the Bank of England's 2% target by the end of 2011 appear to be slim-to-none -- and Slim, as the saying goes, just left town. Deflation is nowhere to be seen.
Can we really be surprised? As Milton Friedman famously said, "inflation is always and everywhere a monetary phenomenon". The world has now had the dubious benefit of extraordinarily lax monetary policy for a decade. The blind refusal of the Greenspan Fed to recognise the dangers posed by the asset-price inflation triggered by its monetary incontinence was a major contributor to the financial crisis. The need to forestall a rerun of the Great Depression meant that the taps have since been opened even further. It would be a major surprise if inflation had not surfaced by now.
If the link between monetary expansion and inflation is well established, the causal connection between monetary policy and growth is much less clear -- yet policymakers around the world are pinning most of their hopes on the existence of such a connection. As Keynes and others long ago recognised, there comes a point when easing monetary conditions is like pushing on a string. Central banks can't force individuals and businesses to borrow -- indeed, as we are seeing at the moment in the UK and elsewhere, they can't even force banks to offer loans. As long as businesses' appetite for risk (animal spirits, in Keynes's terminology) remains depressed, the path to economic recovery will be slow and difficult.
For many countries, including the US and the UK, the task for policymakers as we look into 2011 is made yet more complicated by the persistent hangover from the pre-crisis lending binge. In countries such as Ireland and Spain, irresponsible bank lending led to rampant overconstruction of new housing -- which has, of course, led to its own set of problems, By contrast, in the UK the banks primarily shovelled money into the existing housing stock, inflating its value to an extraordinary extent. Much of the UK press applauds every upward tick on house prices and warns that the sky is falling every time there is a setback. The truth is, however, that the credit-fuelled rise in house prices, largely unaccompanied by any increase in the supply of housing, was almost entirely a bad thing from a social standpoint: a transfer of wealth from the poorer and younger (renters and would-be homeowners) to richer and older (existing homeowners and buy-to-let landowners).
The rise in home values allowed the better-off to borrow still more and to increase consumption. This may have helped to keep the economy growing, but it poses a real problem for the Bank of England now. With fiscal policy set to turn more restrictive, the Bank cannot easily start to tighten monetary settings as well. Indeed, it's under pressure from the media (and of course from the housing industry itself) to keep the monetary taps open so as to ensure that house prices don't fall any further. Yet the Bank must know that the UK can't forever depend on home equity withdrawal as its primary source of growth -- and it must also keep a nervous eye on those nasty inflation figures percolating away in the background.
It appears that the Bank wants to wean the commercial banks off their dependence on its special funding mechanisms during the course of 2011, but it will be difficult for it to do so unless other sources of funding start returning to normal. That may require higher interest rates, in order to start to address the current severe disincentive to savers (0% returns and 3.3% inflation). Raise rates too quickly, though, and the housing bubble may deflate with a damaging bang, rather than a gentle whoosh. No easy choices then, but 'twas ever thus.
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