All Intensive Purposes

Kenneth Rogoff suggests that central banks didn't figure out how to solve inflation; rather, we've just been living in good times that may not last:

Central banks' near universal success in bringing down inflation over the past two decades has led many policymakers to conclude that they have pretty much solved the problem of high inflation, once and for all. . . . Outside a few developing countries, nobody seems to worry much about a sustained bout of 5 per cent or 6 per cent inflation, much less the double-digit levels of the 1970s. But have central bankers truly slain the hydra of inflation?

. . . one should think of the modern era of rapidly expanding trade and technology progress as providing a spectacularly favourable milieu for monetary policy. With hugely positive underlying trends, central banks have been able to establish and maintain low inflation while delivering growth results that have often outperformed expectations. Rather than face the usual historical trade-off, central banks have let citizens have their cake and eat it. No wonder central bankers have become so popular. . . .

Although not every country has benefited from globalisation as much as the US has, the dynamic has tended to be similar. For example, most of the rich countries have seen spectacular terms-of-trade gains; that is, a fall in the price of imports relative to exports. . . . Even in the developing world, which did not necessarily enjoy the same terms-of-trade gains, the move to more market-based economies has brought such efficiency gains that they have still experienced a sharp increase in trend growth. No wonder that central bankers, who are often given credit or blame for long-term growth trends over which they have little impact, have become such big rock stars. What more can one ask for than low inflation and high growth?

There are other more subtle and long-lasting impacts of globalisation on inflation. These include the impact of greater competition, as well as greater wage and price flexibility, all of which operate to make central banks' commitment to low inflation more credible. But the main story of consistently high underlying real growth explains, more than anything, why globalisation has helped central banks so much. Central bankers . . . did not create the computer chip, nor did they liberalise China.

So the question is: what happens if the winds of globalisation turn? What if a combination of economic and political problems leads to a sharp slowdown in China? What if security checks in the wake of a terrorist attack lead to a sustained pause in the expansion of global trade? What if a slowdown in trend growth exacerbates the fiscal problems that most countries are already going to face as their populations age? Or, more immediately, what if there is a disorderly unwinding of the oversized US current account deficit? . . .

Perhaps central banks will get lucky and not have to face any severe problems for another couple of decades but, unfortunately, that is not likely. . . .

Already today, central banks face steeply higher oil prices combined with a pause in falling import prices from developing Asia. But the current conjuncture is just a small test compared with what might happen if globalisation hits a really large bump in the road. Then, at least in a few big countries, inflation will end up being far higher than policymakers or market participants now seem to think possible. Market convictions that inflation is forever dead will be shattered.