Monday, October 20, 2014

Earthquakes and inflation

In November 2010, an open letter to Ben Bernanke warned that quantitative easing would "risk currency debasement and inflation."  Inflation was running at an annual rate about 2% then, and is still about 2%.  A recent Bloomberg news story found that none of the signers of the letter said they had changed their mind:  9 stood by the letter, 13 didn't respond, and one had died.  The basic defense (among those who had a more or less coherent response) was that the letter just said that it was a risk, not a certainty.  Cliff Asness, who didn't respond to the Bloomberg reporters but later posted a reply, puts it this way: "if you believe the risk of an earthquake is 10 times normal, but 10 times normal is still not a high probability, it's rational to warn of this risk, even if the chance such devastation occurs is still low and you'll look foolish to some when it, in all likelihood, doesn't happen."

I was struck by the earthquake analogy, which I've seen before in discussions of inflation.  Earthquakes are sudden--you go from nothing to a disaster in a matter of minutes.  Another image that frequently comes up is "playing with fire," which is the same idea--it can suddenly go from apparently safely under control to completely out of control.  Is inflation really like that?

I  took annual data on inflation in 40 countries since 1950 (from the OECD) and divided it into six categories:  deflation, low (0-3%), medium (3-6%), fairly high (6-10%), high (10-20%), and very high (20+%).  My question was how often countries had gone from low to high inflation in the space of a year.  There were 574 nation-years with low inflation.  Of those, 5 were followed by a year of fairly high inflation, 3 by a year of high inflation, and none by a year of very high inflation.

The cases of a "jump":

Year 0    Year 1
2.9%        13.3%    India 1963-4 
3.0%        10.6%   Norway 1969-70
2.7%         10.5%   Canada  1950-51
2.7 %          7.0%   Sweden 1969-70
2.7%           6.5%   Finland  1970-1
3.0%           6.3%  Czech Rep. 2007-8
2.5%            6.3%  Indian 1978-9
2.8%            6.1%   New Zealand 1966-7

Six of those cases occurred in small nations and two in India, which I'm guessing did not have well developed institutions for economic management.  None occurred in the major economic powers.  France almost made the list, going from 3.1% in 1957 to 15.3% in 1958 (that was the year of the collapse of the 4th Republic).

So if there is a theory implying that quantitative easing created a substantial but not overwhelming probability (say 20% for each year the policy was followed) of a jump in inflation, it's not refuted by the experience of the last four years.  But a theory like that wouldn't fit the behavior of inflation in the past, in which jumps from low to high inflation are rare.

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