It starts with the occasional rock as the policymakers row over the sea of denial. Then many more rocks appear. Finally, they see that they are sailing towards an inflationary cliff. Only with great effort do they turn the ship around and row to safety.
This is how the world is beginning to feel to someone whose life as an economist began in the 1970s. Few wanted to believe Milton Friedman’s warnings. But he was right. The process began to be visible with jumps in prices in what the late John Hicks called “flexprice” markets, such as those for food. Some jumps in prices could be explained away by supply restrictions, such as the oil embargo of 1973-74. In what Hicks called “fixprice” markets we saw excess demand and shortages. But, as price rises became more general and real wages were being eroded, workers became increasingly militant. Finally, a general wage-price spiral became all too visible.
What lay behind all this? The answer is: over-optimism on potential supply, until it was too late. Are we making the same errors now? In my view, yes. Even if the price rises we are seeing could be transitory, they risk becoming permanent. Moreover, even if one is more optimistic than this, it seems impossible to justify present monetary policy settings, especially in the US. Current policy would make sense in a depression. But we no longer risk a depression.
In May 2020, I noted warnings from the monetarist, Tim Congdon, about the inflation to come. In early 2021, well-known Keynesians, notably Lawrence Summers and Olivier Blanchard, joined in, largely in response to the huge fiscal stimulus proposed by Joe Biden. I repeated my concerns about inflation in March and May and on other occasions.
Now, worriers feel vindicated. In a recent column, Summers lays out a detailed response to the “team transitory” view put forward by Federal Reserve chair Jay Powell at Jackson Hole in August. This is not surprising. In the US, headline inflation reached 6.2 per cent in the year to October 2021. Worse, core inflation (without food and energy prices) reached 4.6 per cent. Fortunately, the position looks better in the eurozone and the UK, with core inflation rates of 1.9 and 2.9 per cent, respectively. The European Central Bank’s view that the inflation threat is far smaller in the eurozone than the US looks correct.
Today, as Summers notes, prices are rising in many sectors of the US economy, including housing. Moreover, inflation expectations derived from the gap between conventional and index-linked Treasuries have risen by around a percentage point over the past year. As Harvard’s Jason Furman stresses, signs of pressure are emerging in labour markets. Certainly, the latter have largely recovered. (See charts.)
Nevertheless, one can still note special factors. Among them are surging prices of gas. A detailed analysis by the International Energy Agency describes a number of factors on the demand and supply side — among them that “European underground gas storage levels at the end of September were 15 per cent below their five-year average levels”. So while the strength of demand played a role, it was not the sole factor.
A similar point is the nature of the post-crisis surge in demand, especially the rush to buy consumer durables. This is presumably because many people are nervous about going out to enjoy a meal or some other service. The surge in demand for durables shows up in demand for industrial inputs and so also transport across the world’s extended supply chains. Indeed, Neil Shearing, chief economist at Capital Economics, asserts that the real story “is how well the supply chain has held up given the huge shift in demand towards goods”.
Yet, as time passes, special factors become less credible and worries that inflation will become ingrained more so. With fiscal policy now tightening, even in the US, the burden for macroeconomic stabilisation falls on central banks and especially the Fed. There is no macroeconomic case, however, not to carry through with Biden’s “Build Back Better” programme. This, argues Furman, “would have a minuscule impact on inflation over the medium and long term” and also do much good.
All the big central banks are still largely locked into policy settings introduced in March 2020, at the peak of the Covid-induced panic. In the US, this seems wildly inappropriate. After all, with inflation rising so fast, real short-term interest rates are close to minus 5 per cent, even on the core inflation rate. It is hard to see why this should be the case now. Today’s problems are with supply, not demand. The Fed can do nothing about these.
It may be that the Fed is holding off from the obvious moves towards normalisation because of its shift towards targeting average inflation. Yet it has never made sense to me that the world’s leading central bank should respond to its past failures by deliberately making opposite mistakes in future, a point also made in detail by Willem Buiter. This just adds fresh elements of uncertainty.
Another reason for holding off may be the belief that running the economy “hot” will bring large social benefits and limited costs. That is a good argument for sustaining demand. But it is a risky argument for not responding to rapid rises in inflation. The danger is that outcomes may continue to prove far worse than expected. Then the Fed would be compelled to play catch-up. The costs of that would vastly exceed those of adjusting its ultra-loose policy now.
I very much hope that this inflation will vanish. But hope is not enough. Present policy settings look inappropriate. The Fed needs a new senior management prepared to stand back and think through where the US and world economies actually are. A faster shift towards monetary sobriety now could prevent having to go cold turkey later on.