Is the United States locked in a game of ‘prisoner’s dilemma’ with China, with both sides intent on pursuing policies aimed at furthering their self-interest, even though they will result in a surging global inflation that will eventually punish consumers and businesses in both countries?
Overnight the boss of the powerful US central bank, Ben Bernanke, vowed to continue with his $US600 billion bond buying program, even though he acknowledged that the US economic recovery was becoming more robust.
But even though soaring prices for energy, grains and metals have pushed commodity prices to new records, Bernanke was dismissive of the inflation threat.
“On the inflation front, we have recently seen increases in some highly visible prices, notably for gasoline,” Bernanke told the US House Budget Committee. “Indeed, prices of many industrial and agricultural commodities have risen lately, largely as a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply.”
But, he reassured them, “Overall inflation is still quite low and longer-term inflation expectations have remained stable.”
He pointed out that “core” inflation – which excludes the higher food and energy prices that are included in the “headline” inflation numbers – was only 0.7% in 2010, while average weekly earnings rose by only 1.7% last year. “These downward trends in wage and price inflation are not surprising, given the substantial slack in the economy,” Bernanke said.
In order to tackle these downward price pressures, and unacceptably high levels of unemployment, the US central bank has adopted an extremely loose monetary policy, which includes keeping interest rates close to zero for an “extended” period, as well as its latest bond buying program.
But Bernanke’s determination to continue to boost the US economy comes at a time when many emerging countries – including China – are determined to protect their important export industries by preventing their currencies from rising too sharply against the US dollar.
In a recent note, Morgan Stanley global economist Spyros Andreopoulos notes how this is leading to a classic case of “prisoner’s dilemma” in the global economy.
He notes that Bernanke is currently setting monetary policy for around 40% of the global economy (measured on a purchasing power parity basis). Not only is he setting interest rates for the United States (which accounts for 19.8% of the world economy), he’s also indirectly running monetary policy for those countries which peg their currencies to the US dollar, including China (which accounts for 13.6% of the world economy). Other countries that link their currencies to the US dollar account for a further 8.8% of the world economy.
The trouble is that with most of the developed countries following ultra-expansionary monetary policies – and with their policies being exported to important emerging economies – there is a risk that global inflation will start spiralling out of control.
Andreopoulos argues there are two possible circuit breakers that could prevent an outbreak of global inflation by normalising global monetary conditions. Firstly, the US and other developed countries could raise interest rates. Alternatively, emerging countries could regain control of their own monetary policy by allowing their currencies to rise strongly against the US dollar.
However, he concedes, “neither of these seems on the cards”.
He argues that the US – along with the European Central Bank – is unlikely to tighten monetary policy until the first quarter of 2012. At the same time, he says, emerging countries are unlikely to allow their currencies to rise sufficiently to choke off the global inflation loop, because most have heavily relied on exports to boost their economic development, and are trying to gradually wean themselves off their export-led development strategy.
As a result, global monetary conditions could well fall hostage to prisoner’s dilemma. “In this case, neither side chooses to tighten. That means tightening is delayed, and the inflation genie will be out of the bottle.”
This article first appeared on Business Spectator.
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