Inflation Dragon

Central banks around the world today are in a dilemma. To worry about high inflation or slow growth?

Most central banks do not want to be blamed for an economic recession, so their strategy is to keep a loose monetary policy by keeping low interest rates low - even in the face of inflation.

The argument of central banks today is that the current hike in commodity prices is a one-off increase this year and this will not happen next year.

If this is the case, then the only thing that is happening this year and not next year is the Beijing Olympics.

But prices around the world has been trending up in the last decade or so, even when there were major financial crises and banking collapses saved by expansionary monetary policy.

Higher prices will induce structural changes in economies - where inefficient industries will die and new ones rise. Structural changes are usually undertaken by technological changes - the improvement of production efficiency to feed the ever growing human demand.

A higher interest rate will also induce an improvment in productive efficiency by weeding out inefficient industries. It is less damaging to the general public to use a higher interest rate rather than a higher inflation rate to induce efficiency. But it will be equally damaging to the general public if it has been attracted by low interest rates and speculative gains in real estate or the stock market and has become overgeared.

Too easy a monetary policy by keeping interest rates low for too long will only build a solid foundation for the promotion of inflation. Now that inflation has set in - look at all the prices around us for food and housing and utilities - it will have to take a massive weapon to slay the inflation dragon. And that massive weapon is an economic recession.

We have seen this in the world with the 1973 oil price hike which was followed by a loose monetary policy which the new Fed chief Volcker in 1979 had to tighten and brought a US recession in the 1980s.

Will China save the day?