In discussing inflation, we have to clearly distinguish between the economic cycle and structural shifts that may alter the economic regime medium-term. For now, we see low risk of inflation in the US, Europe and Japan given still high spare capacity. Turning to the major emerging economies in Asia and Latin America, we find a different picture. In these economies, excess capacity is low and we note signs of mounting inflationary pressure. Consequently, our outlook calls for still low inflation in the G4 economies over the 2010/2001 forecast horizon, but higher inflation in emerging economies.

Medium-term, the global economy is undergoing profound structural shifts. It is worth recalling that the Great Moderation of inflation that started back in the 1980s resulted from a combination of positive supply shocks (deregulation, financial innovation, globalization, IT technologies, …) and a deliberate shift to inflation targeting in monetary policy with several central banks granted political independence.

Looking ahead, we see a number of negative supply shocks (tighter financial regulation, higher costs related to climate change, ageing populations, …). This will, for a given level of demand, tend to drive output lower and prices higher. Moreover, in terms of economic policy, a more significant macro prudential approach to financial stability, a potential slippage in central bank inflation targets, and a risk of a return to fiscal dominance with ever growing public debts may imply a new, potentially more inflation-prone regime ahead.

Some observers have suggested that higher inflation can help solve public debt. Is this a solution?

Inflation is not a viable solution to the public debt problem, higher growth and trimming back on public expenditure are. Having said that, inflation can improve the numbers, but it is not a free lunch. Consider the channels through which higher inflation would impact public debt. First, higher inflation would all else being equal increase nominal revenues and nominal expenditure. If expenditures (public wages, pension, benefits, … ) are not indexed to inflation, this will give a saving, but at a real cost to the recipients of these benefits! Second, if market expectations are slow to discount a higher inflationary environment, governments can hope to see lower real borrowing rates, this time to the cost of investors. In sum, inflation acts just like a tax!