Commodity prices continue to rise due to high demand from developing countries, particularly China and India, even though domestic demand is weak and core inflation numbers are both low now and projected to remain low. So what should developed-country central bankers do?
Low core inflation and weak demand sound like they call for additional monetary stimulus. But additional monetary stimulus would not be limited to the United States – it would spill over to other dollar-linked economies, such as China and Latin America, where it would not be welcome. Moreover, it would put pressure on the central banks of other weak industrialized economies – the Euro Zone and Japan – to provide their own monetary stimulus, lest their countries suffer a crippling rise in the value of their currencies relative to the dollar.
The likely end result of substantial additional monetary stimulus by the developed world central banks, then, would be a revaluation upward of the currencies of the major developing economies – China, India, Brazil, etc.
Now, this might look like a feature rather than a bug. A higher Yuan would make American products more competitive in China, which should stimulate employment. But think about the effect on commodity prices. China and India would continue to demand more and more oil. But oil, priced in dollars, would be cheaper in Yuan terms after a revaluation. Of course, this fact would drive up the price of oil, so that it became more expensive in dollar terms. The new equilibrium oil price should be higher than it was before revaluation in dollar terms, and lower than it was before revaluation in Yuan terms. And the same should be true, broadly speaking, for all commodities that are in demand on a global basis.
Demand for oil in particular is relatively inelastic. There aren’t good short-term substitutes for oil – if gas gets more expensive, you can cut down on discretionary driving, but that’s about it. So a spike in oil prices translates directly into a hit to domestic demand for other goods and services. Which, in turn, would require more monetary stimulus to offset.
I’m not suggesting you can’t get any bang for the monetary stimulus buck. I am suggesting that these kinds of feedback effects may mean that getting nominal GDP back to trend could result in much larger price rises for economically-sensitive commodities than people might realize. If getting core inflation temporarily up to 3-4% meant $200/barrel oil, does anyone think that this would be perceived as an economic success? Even if unemployment was dropping as well?
I am no monetary crank, but I have a lot more sympathy for the fears of the developed country central bankers, operating in uncharted territory, than the banks’ left-wing critics seem to have.