Global factors don't determine US inflation
By Scott Sumner
In the comment section to a previous post, I see a lot of misconceptions about inflation. One argument is that inflation is determined by global factors, and that global slack explains the current low rates of inflation. Slack doesn’t explain inflation, indeed the US had more slack in 1981 when inflation was 10% than it does today with 2% inflation. Inflation is determined by monetary policy.
I pointed to hyperinflationary Venezuela, but that doesn’t seem to convince anyone. So today I’ll look at more “normal” countries. While it is true that prices across countries are linked via the “law of one price”, this only tends to equalize inflation rates under a fixed exchange rate regime. Under floating rates, nominal prices can diverge as exchange rates diverge. Consider the UK and Switzerland, which have seen vastly different inflation rates since 1971:
Over the past 11 years, the UK has averaged 2.2% inflation, while Switzerland has had zero inflation. Over very long periods of time, this divergence is associated with a dramatic change in exchange rates:
Just before the Bretton Woods system ended in 1971, the Swiss franc was worth about 23.5 cents while the pound was worth about $2.40. Thus it took more than 10 SF to buy one pound. Today the SF is around a dollar and the pound is about $1.28. It seems very likely that the SF will eventually surpass the pound, due to Switzerland’s persistently low inflation rate. However, the exact date this will occur is difficult to predict, as purchasing power parity doesn’t work very well in the short run. Rather, PPP is most useful in explaining very long run changes in exchange rates.
Here’s the key point. Both Switzerland and the UK face the same price for imported wheat, copper, oil, and Toyotas. Both face periods of global slack followed by periods of global growth. So you can’t explain this divergence in inflation rates by pointing to global factors. Ironically, Switzerland has actually had unusually high inflation relative to the UK, when you account for changes in the exchange rate. If PPP held perfectly, then Swiss inflation would have fallen even further below the UK rate. Swiss inflation was a bit higher than predicted by PPP because during this period Switzerland became a very high cost place for non-traded goods, partly due to very high wage rates and property prices.
But the big story is monetary policy. Swiss inflation has been far lower than UK inflation for one simple reason. They’ve run a tighter monetary policy. Global factors do not determine inflation.
If there were a global recession and central banks foolishly followed Keynesian policies of targeting interest rates, then it’s quite possible that almost all countries would see a temporary dip in inflation, rather than the sort of increase that is appropriate during a recession. But that’s not because global factors are determining inflation in any technical sense, rather it’s because many central banks make the same sort of mistakes. (Israel and Iceland are exceptions, they are smart and have pushed inflation higher during recent recessions.) But even when changes in inflation rates are correlated across countries, the trend inflation rates still vary, depending on local monetary policies. Switzerland will likely have lower inflation than the UK during the next global recession, because it has tighter money.