Silence from central banks speaks volumes

Until recently, these institutions could be relied on to regulate money supplies and keep inflation under control. But times have certainly changed.

Food prices can cause economic unrest.

Can central banks contain inflation? We once thought they could. During the past 20 years, central banks around the world, including the US Federal Reserve, pursued price stability with remarkable success.

But now, after the financial crisis, a tide of distrust is sweeping the world.

In the US, the Tea Party has made a return to the gold standard a part of its platform and Utah is debating making gold and silver coins legal tender.

German inflation worries have pushed the government into a much harsher stance on debt relief in Europe. In China, fear of inflation is unleashing large-scale discontent.

Inflation fear was already present before the new challenges of this year raised questions about long-term energy prices. As protests shake Middle East and North African region regimes, the prospect of sustained conflict threatens a global economy still dependent on oil, while the aftermath of the Japanese earthquake and nuclear accident raises doubts about the security of nuclear energy.

The main anchor of central banks' monetary policy in the past 20 years was an inflation-targeting framework. After successful experiments in smaller economies - New Zealand in 1990, then Canada in 1991 and later in Sweden and the UK - the conviction developed that the new approach represented a superior way of dealing with the problem of inflationary expectations.

The really large currencies - the dollar, the euro and the yen - were never managed explicitly or solely on this principle. But central banks in Europe and the US thought a 2 per cent annual inflation rate would be a desirable target.

There was always a problem in this approach, namely that the general price level is an abstraction. It is useful in a context of overall stability but, especially during crises, there are sharp movements of relative prices.

At these moments, it is easiest to accommodate the movements by letting all prices rise but to differing extents. Some econometric attempts have been made to identify long-term cycles in both inflation and monetary growth.

Luca Benati, the economist, has identified such surges of underlying inflation in the last decades before the First World War, the late 1930s, the late 1960s and the 1970s. He has also found evidence of a pick-up in long-term underlying inflation in the UK and the US since the early 2000s.

The debate in the 1970s has become relevant again. The oil price shocks that came after 1973 led to protests in many poorer countries, as other key commodity prices increased.

As in the 1970s, there are more links than may at first appear between the apparently new problems of this year and last year. Food and energy prices are more likely to be affected by monetary policy. And they produce an economic basis for discontent, which played at least some part in triggering the protests of the "Arab spring".

Given that food and energy prices respond to monetary developments, the concept of "core inflation" obviously becomes problematic, to say the least. One consequence is that Fed officials now try to avoid it. Another approach is to try to grasp changing consumer behaviour.

As a result, inflation is continually being redefined. In the UK, the consumer price index is being recalculated to include new products, such as electronic dating services. It is easy to suspect that this is not just a concession to changing social mores, but that it also reflects a desire to include as many declining prices as possible.

This is less radical than the method adopted by Argentina, where high levels of inflation are both a historical nightmare and a current challenge. There, the government, whose statistical agency puts annual inflation at 10 per cent, is punishing private-sector economists who release much higher estimates, typically about 25 per cent, with heavy fines.

But statistical manipulation simply erodes confidence. A better approach is to think of the longer-term story as being one of changes in relative prices, which are not well handled by a consumer price index.

That issue is especially acute after the property crisis in the US and parts of Europe. Until 2007, many people financed consumer purchases by borrowing against their houses, which were rapidly rising in value. Consumer goods therefore seemed to be getting cheaper.

Now, by contrast, food and petrol prices are rising because of the boom in emerging markets, while house prices continue to plummet.

It is when we worry about relative prices that we become angriest about monetary policy - and when central banks seem to offer no answer.

Harold James is professor of history and international affairs at Princeton University and professor of history at the European University Institute, Florence. His most recent book is The Creation and Destruction of Value: The Globalization Cycle

* Project Syndicate