Sunday, June 11, 2006

Inflation rate - why do Central Bankers focus on such a low rate?

I was speaking to an audience of central bankers from over 25 countries last week for BNP Paribas in Nice...


For the last few years many countries have been chasing an inflation rate of around 2-3% which is almost zero compared to some of the highest rates we have seen in the past.  There is a new generation growing up that have no memory of significant inflation who could be forgiven for wondering what the obsession with low inflation is all about. 


In any event it is hard to find an absolute logic for such a 2-3% level.  The real issue of course is stability, and the risk of a rate that hovers around 2% or less is that there will be some kind of deflationary shock with all the damaging consequences we have seen in Japan.


Most central bankers focus on inflationary shocks – for example a further hike in oil prices.  But you do not need much imagination to see that things could go the other way. 


An obvious example would be an outbreak of a bird flu derived virus that appears to be spreading fast with an uncertain mortality rate.  While such an epidemic could turn out to be far less serious than the most optimistic forecasts for a bird flu mutation, most bankers I have talked to recently would consider that the impact could affect investor confidence as well as public behaviour.


My own straw polls of executive audiences around the world suggest that few human deaths would be needed from the first 50,000 cases of a rapidly spreading mutated bird flu to cause up to 25% or more of the entire workforce to stay at home “just to be on the safe side”, especially those worried about taking their children to school.


While no one can be sure what the economic impact would be of a more serious pandemic, it would be wise to consider the possibility that many prices could fall by more than 2-4%, and that a country that is “stabilised” around an inflation rate of only 2% could therefore be at risk of deflation in such a situation.


Future generations may feel that the current targets were too low, and the anti-inflationary policies were unnecessarily severe.



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Anonymous Jeremy Baldwin said...

Hi Patrick

Hope you are well. I was interested in the Central Bankers opinions on the deflationary impact of a pandemic. This assumes a demand shock. However, given the extent of globalization, few people seem to be talking about a supply shock, which would obviously have inflationary implications. What do you think?

Jeremy Baldwin

2:31 AM  
Blogger Dr Patrick Dixon said...

Yes I think you are right - there are bound to be some supply shocks if a pandemic of a mutated bird flu were to disrupt manufacturing, wholesale or distribution - the latter would be the most acute problem perhaps with drivers not turning up for work etc.

However the Central Bankers were thinking perhaps more of a situation where people stockpile and then stay home, consuming almost nothing, with unsettled investors everywhere.

4:13 AM  

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