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Inflation memories run deep at central banks

Source: Reuters - Fri 7th Aug 2009

Central bankers' experience of soaring prices in the 1970s and the damage it can wreak on ordinary people's lives may shape their commitment to avoiding inflation once the worst global credit crisis since the Depression of the 1930s subsides.

Policy-makers in the United States and Europe have pumped trillions of dollars into the global financial system in the past 18 months to get markets moving again, worrying some economists that inflation will result as economies begin to recover.

The so-called "Great Inflation" of the 1970s had a marked impact on people's lives, with the value of savings being undermined, along with the purchasing power of fixed incomes like pensions, as prices rose.

Annual U.S. inflation increased from 1.4 percent to 13.3 percent from 1960 to 1979, while economic growth stagnated.

"Just about every member of our committee was schooled on that experience", said Janet Yellen, San Francisco Federal Reserve president and member of the policy-setting Federal Open Market Committee.

"It was a formative event for me and for most of my colleagues that made us want to go into the field of central banking."

This personal experience may underscore central bankers' commitment not to keep monetary policy too loose for too long.

In Fed policy-makers' most recent speeches the 1970s was referenced roughly as often as the Great Depression. 

Federal Reserve chairman Ben Bernanke may have spent much of his academic career studying the Great Depression, but in the late 1970s, he was a student studying for his doctorate at the Massachusetts Institute of Technology.

"Studying something academically gets you to be very familiar with it but it doesn't give you the emotional understanding" said Dan Ariely, a behavioral economics professor at Duke University and author of "Predictably Irrational - The Hidden Forces that Shape Our Decisions".

"Seeing something firsthand is going to be an incredibly salient and emotional experience, which you would expect would impact people's decision-making" Ariely said.

AGE MAKES A DIFFERENCE

In the 34 Gallup Polls taken from 1973 and 1981 in which Americans were asked the question about the "Most Important Problem Facing the Country", the issue of "inflation/cost of living" was ranked the number the one problem in all but one survey.

Most current Fed policy-makers were in their 20s in the 1970s and were either studying or in the early stages of their careers at the central bank.

"One of the things we know about development of tastes is that we are open to influences up to a certain age usually in our 20s and then we become fixed. The same thing could be argued about expectations about finance" Ariely said.

A working paper by University of California at Berkeley's Ulrike Malmendier and Stanford Graduate School of Business' Stefan Nagel found that living through the inflation of the 1970s had a significant impact on inflation expectations for years. And there was a difference between young and old.

The average inflation expectations at a 5 to 10 year horizon of those who were under the age of 40 in the late 1970s and early 1980s exceeded those aged above age 60 by several percent, the study found. 

This could be because the life-time experience of the younger group was dominated by the high inflation years, they said. The difference didn't fade away until the 1990s.

But, said Scott Pardee, who ran the New York Fed's foreign exchange operations in the 1970s, there is a difference between experiencing inflation from the outside and working on the frontlines trying to fight it.

"The current policy-makers may remember what rising prices felt like, but they didn't experience how difficult it was to bring them under control" said Pardee, now a professor at Middlebury College.

That feeds into the worry some lawmakers have: that Bernanke's academic focus on the lessons from the Great Depression means he may be underestimating the strength of character it will take to avert inflation once the economy begins to recover.

"Do you have the will as former Chairman Volcker did to tighten even if the economy is still weak?" U.S. Senator Jim Bunning asked Bernanke last week, referring to Paul Volcker, the Fed chair from 1979-1987 who is known for crushing the inflation of the period.

THE EUROPEAN EXPERIENCE

Just as the Great Depression is viewed as the United States' national trauma, hyperinflation in Germany in the 1920s deeply scarred Europeans.

Inflation, therefore, has long been seen as Europe's bogeyman, as hyperinflation in the 1920s financially ruined the middle class in Germany, its largest economy.

But as with U.S. policy-makers, that explanation ignores the personal experiences of European policy-makers. 

In recent speeches by European Central Bank and Bundesbank policymakers, only two, including one by ECB president Jean-Claude Trichet, talked of the German scars of hyperinflation in the 1920s.

Instead, European policy-makers have recently mentioned the 1970s significantly more often than hyperinflation or the Great Depression.

Juergen von Hagen, a University of Bonn economics professor said that since there is no threat of hyperinflation today, the lessons of the 1970s loom larger for the monetary policy makers.

"Germans being afraid of hyperinflation is a popular argument outside of Germany, but there is not much truth to it, I think. Hyperinflation does not feature in the economic discussion in Germany" he said.

Nevertheless, inflation-fighting credentials are paramount for policy-makers in Europe. The current head of the European Central Bank, Jean-Claude Trichet, earned his inflation fighting bona fides in the 1990s as French central bank head, when he kept French inflation below 2.0 percent, and at the ECB he has resisted calls from politicians for lower rates.

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