Central bankers' window to go for broke

Falling price pressures around the world will allow central banks to increase their use of monetary stimulus to boost growth, according to MIT economics professor, Albert Cavallo.

In an interview with Business Spectator, Cavallo said the world was now witnessing global disinflation. Indeed, there are now only three countries where inflation is not on a downward trajectory – Russia, South Africa and Brazil.

According to Cavallo, the "good news” about this disinflationary trend is that it gives central banks the flexibility to use yet more monetary stimulus in an effort to boost growth.

The European Central Bank is widely expected to cut its key interest rate this week from 1 per cent to 0.75 or even 0.5 per cent. Cavallo pointed out that the central bank is more likely to take this step now that price pressures in Germany, which had been relatively strong at the beginning of the year, are clearly subsiding.

"Now that inflation in Germany has stabilised, and is falling, the European Central Bank has more freedom to cut interest rates. Even German policy-makers will be happier to take that step," he said.

Cavallo is also confident that European politicians will be able to avoid a break-up of the eurozone. "I'm quite optimistic about that. Politically, the eurozone is very important.”

Instead, he said, European politicians will probably continue to make incremental steps towards resolving the crisis, similar to those at last week's summit. Germany, he said, "will complain considerably about the misbehaviour of other countries, but in the end it will step in and provide support”.

Cavallo, who is the co-founder of the State Street PriceStats Inflation Series, which uses price information from hundreds of online retailers around the world to gauge inflation trends, said that his data showed that US inflation had been falling since March last year.

The US consumer price index has now caught up, and is reflecting this decline.

Waning US prices pressures, he said, means that the US Federal Reserve now has the flexibility to launch a third round of bond buying, dubbed QE3 by the markets.

However, he considered that the US central bank would be wary of the political risks of launching a large QE3 program before the upcoming US presidential election. "It will happen after the election. I don't think the Fed will take a bold step before then.”

Chinese inflation is also subsiding, which Cavallo said pointed to a slowdown in the Chinese economy. He noted that PriceStats data showed that inflation in Chinese supermarket prices peaked in March/April last year, and have since been falling consistently. "Our data shows that supermarket prices are now stabilising at around the 3 to 4 per cent level.”

Even more striking are fresh food prices, which had been rising at an annual rate of 12 per cent a year ago, and which were the main driver of Chinese inflation. At present, Cavallo said, fresh food prices are steady.
"The Chinese central bank has been quite effective in controlling the rate of inflation”, he noted.

According to Cavallo, central banks need not worry that extra monetary stimulus will lead to an outbreak of inflation down the track.

"Central banks are pretty sophisticated and they have enough tools to control the situation if they need to. Inflation shouldn't be something they focus on in the short-term. Instead they should be pragmatic and worry about growth.”

He added that provided that inflation didn't climb above the 4 to 5 per cent level "it's relatively simple to bring it back under control”.