Will The Falling Dollar Cause Inflation?
According to popular tradition, one particularly harmful affect of a depreciating dollar is the prospect of an uptick in consumer price inflation. Denial of this self-evident truth is usually met with a vitriolic tirade of ad hominem attacks, straw men arguments, and comments about the sobriety of your mother during pregnancy. Yet, just how much truth is there to the phrase “a depreciating currency spurs domestic inflation?” According to some new evidence, the correlation between a depreciating currency and domestic inflation is low and falling.
Recent Macro Evidence: Pass-Through To Consumer Prices
In a March 7, 2007 speech at the *Norges Bank Conference on Monetary Policy in Oslo, Norway, note monetary policy scholar Frederic Mishkin makes the case that consumer price inflation is not highly correlated to currency exchange rates i.e. the value of the dollar. This, of course, runs somewhat contrary to traditional monetary theory which states price inflation is primarily caused by an increase in the money supply. But as always, the real world proves a bit more complicated than textbook theory would have you believe. While there are certainly examples of currency depreciation and domestic inflation going hand in hand (Mexico 1977-95, Sweden 1973-1985), the data seems to suggest this high correlation between currency depreciation and domestic inflation is due not so much to high rates of currency devaluation but rather to situations where unstable and unpredictable monetary policy exacerbated a series of nominal external shocks (spike on oil or wheat prices, etc). Mishkin stated as much directly,
“…a salient feature of the data is that this correlation (Ed: between currency devaluations and price inflation) has been very low over the past two decades for a broad group of countries that have pursued stable and predictable monetary policies. Moreover, the evidence suggests that even countries in which inflation and exchange rate depreciation appear to have been fairly closely linked historically have experienced a sizeable decline in pass-through following the adoption of improved monetary policies.”
Examples abound of industrial nations experiencing little if any upward inflation pressure after a significant drop in their currency. Take the United Kingdom, for instance. After withdrawing from the Exchange Rate Mechanism of the European Monetary System in late 1992, the UK experienced a mild 2% inflation rate over the next two years even as the Pound Sterling dropped in value by over 15%.
Why The Falling Dollar Won’t Necessarily Cause Inflation
A widely-cited study by Gagnon and Ihrig (2004) of the amount of pass-through from currency devaluation to domestic inflation among a wide sample of industrialized nations (not just the US) was found to be about 0.2, meaning that for every 10% drop in the value of a given currency, long-term inflation would increase by about 2% (after taking the rise in import prices into account). Not ideal obviously, but at the same time it suggests a 50% drop in the value of the dollar will increase the long-term rate of inflation by only about 10% or so, which certainly isn’t the end of the world.
It gets better, however. When the study set independent break points for each nation corresponding to the emergence of more stable and predictable monetary policy over the same sample, the same pass-through was estimated to be only about 0.05, meaning a 10% drop in the value of a given currency would increase inflation by only about 0.5%. In this case, even a seemingly catastrophic 80% drop in the value of the dollar would only increase inflation by about 4%. Of course, this estimate could be low and as we know, past returns are no guarantee of future results but even in the worst plausible scenario, inflation should be modest in global terms.
Intelligent Monetary Policy Is Key
Obviously, this soft-landing scenario depends on adept and intelligent monetary policy by the Federal Reserve, which may be a bit of a stretch to many. The validity of the models used in this study also rests on certain reasonable (yet by no means guaranteed-to-be accurate) assumptions. But at worst, we are looking at low double-digit inflation rates like those briefly experience in the early 80’s. Sure it was bad for a while, but it was over relatively quickly and we survived. Hyperinflation isn’t even with the realm of plausible possibilities, despite the insistence of the Ron Paul gold-bug enthusiasts. In invite you to carefully read Mishkin’s full speech and evaluate the primary sources cited to gain an understanding of the complex relationship between exchange rates and inflation.
*Mishkin, Exchange Rate Pass-Through and Monetary Policy–March 7, 2008
Are you kidding? Double-digit inflation is not fun and is becoming more and more likely. Gold was up 30% last year and could be up a lot more this year. Oil is up 90% this year and could double is the next few years as the dollar drops. I know, no body wants to read about this and they all want someone to give them hope and tell them that everything is going to return to normal, but it’s just not very likely to happen anytime soon.
I think sustained double-digit station is still extremely unlikely. We may hit double digits briefly, but I highly doubt this will be even as bad as 70’s stagflation. Nobody said it was pleasant, but it isn’t that bad, either. Oil is just one component of inflation, and the evidence shows it does not spur inflation in all other products like popular wisdom suggests. The price of gold is irrelevant to inflation. It is subject to its own supply-demand curve. Contrary to popular legend, the value of gold does not hold steady while the value of the dollar fluctuates around it. The true economic value of gold fluctuates along with everything else.
The high price of oil is a result of the weak dollar, which is already becoming a major contributor to inflation.
Inflation is already at double-digits in many places throughout the world, here are a few Venezuela (22pc), Vietnam (21pc), Latvia (18pc), Qatar (17pc), Pakistan (17pc), Egypt (16pc) Bulgaria (15pc), The Emirates (11pc), Estonia (11pc), listed in this article.
“OECD warning as stagflation goes global”
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/14/bcnoecd.xml
If the government calculated the CPI numbers like they did in the 70’s, we would already have double-digit inflation. How could a nation that imports almost everything have a currency that is loosing 8-10% per year have a 2.7% inflation? It just doesn’t add up.
I think it’s going to be much worse then it was in the 70’s, if the dollar continues to weaken and if the Fed monetary policy doesn’t change soon - we could see 30-50% inflation over the next 5 years.
The economic data about low inflation, the bottom of the housing market and the rallying stock market produced by the government and the financial media have been nothing but a dillusion.
I do agree with you that it’s not that bad - yet - but only because I believe it’s going to get a lot worse.
Not much to say except that I respectfully disagree with you. The way inflation was reported in the 70’s was provably mathematically incorrect. It did not control for many relevant variables such as substitution and product quality so by definition, the statistic was invalid. Inflation methodology isn’t really generated by the government, it’s generated by academia. The government merely runs the numbers: they don’t control where the data came from or the methodology used to compute CPI. Many industrial nations with a large percentage of imports (UK in the 70’s for instance, or Sweden) have had severe drops in their currency with minimal impact to ther domestic inflation rates. It’s happened before in many different nations, so it’s not unreasonable to think it could happen here as well.
I have no opinion on whether or not housing is at a bottom or not. Too difficult to tell.
I also respectfully disagree with you. Maybe I could host a debate on my blog sometime and we could further debate this issue to create an exciting read. Are you interested?
Great post and enjoyed reading the comment exchange. Had a recent piece on the US dollar outlook myself and like the perspective here.
what an absolute load of tripe. seems to me that this clown fails to take chinese currency manipulation into account. if he did he’d have his answer as to why inflation has been low for so long.