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Betting on inflation 12 months hence

By Henry Thornton - posted Tuesday, 2 November 2010

Monetary policy cannot successfully operate by looking in the rear view window.

Nor can it make do with reports from the current economy, no matter how well-informed.

The problem is that monetary policy takes time to influence the economy, so central bankers have to act on where they think the economy will be in a year or two.


This is why all the knee-jerk reaction by bank economists, screen jockeys and journalists to a particular piece of economic data is so irrelevant. Some months an especially strong jobs result (a glimpse in the rear-view mirror) produces a chorus of "rate hike to come".

Then a slightly lower than expected goods and services (CPI) inflation outcome (another glimpse in the rear-view mirror) causes the pundits to assert that the Reserve Bank has time to think before it raises interest rates. Both responses are irrelevant.

The problem with being a central banker is that one comes to live in the future. Like any other serious job, total immersion is required. The challenge of total immersion in the uncertain future is that it can be difficult to return to the present on those rare occasions that require attention to the here-and-now.

The task facing the Reserve Bank board today is to decide whether, with current (and projected) policies, goods and services (CPI) inflation in a year or two will be above or below the "target range" of 2 to 3 per cent.

Question one is where the world economy will be in a year or two. The staff of the bank may have access to global forecasts that they trust, but this writer does not, so we shall have to go country by country, the old-fashioned way.

The US Fed is deeply concerned about weakness of the US economy and is contemplating more "quantitative easing", which means printing money. Printing money is inflationary, but unemployment at close to 10 per cent and underemployment perhaps of the same order to this is deflationary. These factors may be assumed to be approximately offsetting, but a cautious governor might feel that inflation is the greater risk.


Euroland is mostly just as depressed as the US, with the exception of Germany, so similar logic prevails. However, there is the additional factor of Euroland and American sovereign debt to consider. The Western prosperity of the past 30 years has been built on growth of private debt. Expectations about future sovereign debt have exploded because of the dramatic easing of fiscal policy designed to limit the negative effects of the global financial crisis.

While I have warned of the dangers of driving with eyes on the rear-view mirror, the lessons of history, properly understood, are the best guide to the likely future.

There are two main historical responses to sovereign debt -- default or inflation. Default may seem the better option if the debt is mainly owned by foreigners, unless they can retaliate, while inflation may seem better if the debt is mainly owned by a country's own people.

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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at

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