LONDON (Reuters) - If accelerating global inflation is to be the real legacy of credit crisis, watch closely the relationship between central bankers and their political overseers for clues to any potential policy accident.
The sheer scale of monetary and fiscal pumping required to prevent a collapse of the global financial system over the last two years and a resultant economic depression has been enough to spook even the most price-sanguine economists.
Near zero interest rates in the United States, euro zone, Japan, Britain, Switzerland and Sweden and active bond-buying or money printing in many of these countries would have been inconceivable for these central banks just three years ago.
In tandem with government spending injections totalling two percent of the economic output of the Group of 20 economies, it's not hard to see why price worriers have had a field day.
Gold prices, historically seen as the definitive inflation hedge, have nearly doubled since the credit crisis first gripped in 2007.
For sure, the medicine has worked, at least to the extent it prevented the much-feared economic meltdown and triggered the sharp, liquidity-fuelled bounceback since last March.
But the big concern is that central banks -- now juggling sometimes competing goals of financial and economic stability along with inflation targets -- remove monetary stimuli too late to prevent the flood of emergency money and cheap credit driving up prices and draining consumers' purchasing power.
As these economic stimuli act with variable lags, the timing of policy 'normalisation' is inherently tricky anyway. But political pressure on central banks to keep the hoses on for longer is seen as a far greater threat to long-term stability.
Studies of the last time consumer price rises were allowed to get out of hand -- the so-called 'Great Inflation' of the 1970s -- point the finger less at incompetent central bankers than at interfering lawmakers.
In a paper out this week, Stanford University professor and former U.S. Treasury diplomat John Taylor and Federal Reserve economist Andrew Levin debunked many theories of why inflation expectations were allowed to bolt 40 years ago. Most of these theories had laid the blame at the door of the Fed itself.
Variously the Fed had been seen as guilty of anything from rigid adherence to outdated models on wages and prices; for misreading data on the "natural rate" of unemployment and the amount of slack in the economy; or for simply mistiming interest rate decisions that exaggerated stop-start economic spiral.
OUT TO THE WOODSHED
But Taylor and Levin reckon all of these theories were faulty and that political influence was a bigger culprit.
They cited incidents such as former President Lyndon Johnson taking then Fed chairman William McChesney Martin "out to the woodshed" in 1965 following a discount rate rise and transcripts of President Richard Nixon's office recordings telling sitting Fed chief Arthur Burns of the "myth of the autonomous Fed."
Only when Fed accountability was clarified in the 'Full Employment and Balanced Growth Act' of 1978 was it possible for Fed Chairman Paul Volcker, with the backing of President Ronald Reagan, to turn things around in the 1980s, they argued.
"The most plausible explanation (for the Great Inflation) is a combination of periodic political pressures on the Federal Reserve and a lack of clear guidelines that would have helped policymakers to resist those pressures," the paper concluded.
Taylor, famed for his 1993 'Taylor Rule' outlining a basic formula for interest rate changes, naturally advocated adherence to simple and transparent monetary rules as a solution.
The application of such rules as well as persistent faith in the resolve of the post-Volcker Fed and the inflation and money supply targeting of European central banks means that 5-10 year inflation expectations now seen in bond and consumer surveys remain relatively contained between two and three percent.
Yet the issue of political influence is very much alive in the minds of those who feel seeds of inflation are being sown.
Even though incoming economic data suggests economic slack is sufficiently large to keep inflation at bay in most countries for now, there are gnawing concerns about the political firestorms central banks may face when they do try to tighten.
THE NEXT CRISIS?
For a start, implicit or explicit inflation targets could be compromised by the greater role of financial sector stability variously handed to the Fed, European Central Bank and Bank of England. What, for example, would happen if inflation forecasts warranted sharp interest rate rises but those rate rises risked destabilising domestic banks?
But, more pointedly, many governments are facing enormous debt burdens as a result of the financial system bailouts and higher interest rates could well wreak havoc for debt servicing costs and national budgets everywhere.
Before they even get there, the pressure on central banks to keep buying domestic government debt -- as they currently are in the United States, UK and Japan at least -- will be intense too.
And if this is true in Washington, London and Tokyo, then the political strains in Athens, Dublin, Madrid and Rome are potentially even greater -- even though the ECB's 16-nation makeup may, unintentionally, be its biggest shield.
Either way, it is not difficult to see why hard-won and jealously-guarded central bank independence is no longer the basic assumption it was only three years ago.
"The next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation," economists at Morgan Stanley said in a new year note.
"Sovereign risk translates into inflation risk rather than outright default risk."
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