Wednesday, May 28, 2008

Developing countries need to follow a more market-based approach to exchange rate management

A brief history of inflation
Alok Sheel, Business Standard New Delhi May 25, 2008, 2:01 IST

Secondly, the changing nature of inflation in a fast globalising world was also conducive to a lax monetary policy. Disinflation was largely limited to tradable value-added goods and services. The relative prices of mostly non-tradable assets, as well as commodities — including agricultural commodities — actually rose because of hyper-growth in developing countries, another by-product of globalisation.

Inflation consequently had a ‘non-core' bias, whereas disinflation had a ‘headline' bias on account of the predominance of tradable manufactures. Even as headline inflation was low, commodity and asset prices were entering a period of unprecedented boom. The Schiller index of real home prices (1890=100), which fluctuated within a relatively narrow band on either side of 110 between 1970 and 1997, rocketed to a peak of 200 in 2006. This insidious inflation lulled central banks into following a loose monetary policy since the US Fed, in particular, targeted core inflation that excluded commodity and food prices. A loose monetary policy also facilitated hyper-leverage, especially in the unregulated non-banking segments of the financialsector, which further amplified liquidity and demand.

If the above diagnosis of the resurgence of global inflation is correct, the prescriptions for addressing emergent hyperinflation over the short to medium term are self-evident. Developed countries need to look beyond core and headline inflation, and also target commodity and asset price inflation while formulating monetary policy.

Developing countries need to follow a more market-based approach to exchange rate management. Price and market signals should not be tampered with so that supplies of commodities, including oil and food grain, can rise and efficiency gains effected to equate demand and supply over the medium to long term.

The writer is a civil servant. The views expressed are personal. Data based on IMF, US Federal Statistics, US Federal Reserve and The Economist websites
Alok Sheel Previous Columns
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