TCS Daily

Inflation: The Fed vs. Energy Prices

By Christopher Lingle - October 19, 2005 12:00 AM

NEW DELHI -- Fingers are being pointed at increased demand for energy from the fast-growing economies like China and India, or OPEC for its venal pricing, for pushing up oil prices. In turn, the recent upward spike in prices has unleashed fears of oil-fuelled inflation.

But this notion is based upon the mistaken notion that consumer prices tend to increase either due to cost-push or demand-pull influences, a pervasive economic fallacy. It turns out that there is only one type of inflation and there is only one source. And that cause is artificially-cheap credit engineered by loose monetary policies of central banks.

Central bankers around the world claim they must consider raising interest rates due to the doubling of oil prices over the past 24 months to breach $70. Following the cost-push fallacy, they suggest that higher energy costs could lead to rising consumer prices and higher inflationary expectations that could spark a round of demands for higher wages. In turn, rising costs and inflation would cause economic growth to be lower and unemployment to be higher.

While economic theory has debunked the notion that rising costs can push up consumer prices, media commentators cling to this misguided notion. Rising consumer prices cannot be blamed on increases in wages or rising commodity prices like oil because all these are results of an inflated money supply.

As important as they might be, rising oil or other energy prices cannot be the primary cause of higher consumer prices. For this to be true, the quantity of money would have to be passive and adjust itself to accommodate increases in input costs.

However, the reverse is true in that overall costs can only rise when there is an excessive expansion in credit or the money supply. Unless there are offsetting increases in money supply or credit, higher oil prices would force down all or some other prices.

Costs and prices can only rise in all or most sectors if the central bank engages in monetary pumping by loosening credit policies by lowering benchmark interest rates. As such, rising energy costs cannot push up most consumer prices in a sustained manner. But an increase in these costs could lower productivity increases so that capital investment is inhibited and job growth stunted so that unemployment would rise.

Higher energy prices need not cause a slowdown in economic growth. As it is, such outcomes are more likely if governments try to delay the inevitable adjustments. For example, paying subsidies to farmers to offset rising oil prices only hides the immediate costs while shifting them to the future.

Rising input costs and higher consumer prices should be understood to be the result of interest rates being kept at record lows and economies being flooded with new money and credit. In the end, the damage has been done by irresponsible central bankers.

Data from the Fed indicate that money supply growth measured as M1 expanded by about 23 percent from January 2001 to July 2005, mostly in the form of bank deposits. China's monetary expansion has been much more rapid with its M1 growth at about 14 percent over much of the same period.

When a central bank pursues a policy that induces commercial banks to increase deposits through making loans, the newly formed credit is not based upon genuine savings. And so it is that despite China's very high savings rate, much of the investment is based upon artificially-cheap credit.

Like in the US, the People's Bank of China pushed interest rates below market levels so that enterprises invested in production that is not supported by sufficient real savings. Pumping more pieces of paper money into the US and Chinese economies created temporary growth since people could consume without a prior increase in production.

In this sense, "nothing" in the form of new money was being traded for "something" in the form of goods and services. Eventually, there will be a reckoning in the same way that people that had unknowingly accepted counterfeit money will eventually begin to refuse to accept the bills at the original rate.

As it is, much of China's high growth is supported by domestic monetary pumping and unsustainable import demand from the US based upon the Fed's loose monetary policy. And while much of India's economy is the result of reform, there is considerable air in its economy and on the Bombay stock exchange due to a massive amount of excess global liquidity.

As short-term interest rates are ratcheted up around the globe, there will be a slowdown in economic activity in the coming months that will reduce the upward pressures on oil prices. As this begins to happen, listen for the popping of bubbles around the world.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi and Professor of Economics at Universidad Francisco Marroquin in Guatemala.


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