Brigitte Granville, Professor of international economics and economic policy, Queen Mary University of London.
The US Federal Reserve has just reassured the markets that it does not expect inflation to get out of hand in the forthcoming months. It comes as concerns regarding serious inflation damaging the global market have reached fever pitch, especially since recent Labor Department data showed that American inflation climbed 4.2% over the 12 months ended April — the highest since the global financial crisis of 2007-09. In the euro area, inflation seems certain throughout the remainder of this year to split over the European Central Bank target of”close to but below 2%”.
Central bankers on both sides of the Atlantic state that these price rises are a temporary result of the whiplash effect of the COVID-19 pandemic on demand. Supply chains in everything from products to semiconductors are disturbed by demand first collapsing and then surging back, which makes prices really volatile. With this rationale, inflation will settle down once the pandemic recedes. Critics point to the dangers of cost pressures setting off a chain reaction in which everybody anticipates future price increases, resulting in a true inflationary episode where prices persistently increase across the board. This debate about the near-term outlook is matched with an equally lively debate about long-term inflation, about drivers such as the effect of baby boomers retiring, China’s shifting workforce, automation and so on. So who is right in all this? Are the inflation numbers a blip or are we seeing a storm?
Courses of the 2010s
My timing with that publication was bad. The global market’s faltering recovery from the global financial crisis was overrun from the opposite problem — deflation — in which people expect prices to collapse. As overstretched firms and households retrenched during the early 2010s, it should have dropped to governments to generate needed demand by ramping up public spending. Rather, stylish notions of balancing the books using austerity got at all.
UK inflation rate 1960-2021 | US inflation rate 1960-2021
Central banks were left to perform the heavy lifting by cutting headline interest rates and using unconventional monetary policies like quantitative easing (QE) — that is, ”printing money” — to buy large amounts of government bonds and other monetary assets. This helped to push down long-term interest levels — into negative territory in Europe — making things like mortgages and business loans more economical.
Yet the only ”inflation” that resulted was increasing asset prices in everything from land to stocks and stocks. It made the rich richer, engendering even broader inequalities than previously. All of the time, official consumer price inflation — that refers to the average change in prices of a basket of specific household products — stayed persistently below the 2% level targeted by the major central banks.
According to what is called the Phillips curve, inflation must have been aroused by the fact that unemployment dropped in countries such as the UK, but it turned out this relationship was suspended.
House prices prospered from the 2010s.
One reason – especially apparent from the US – was that the falling rate of unemployment was blindsided by increasing numbers of people giving up looking for work and dropping out of the labor force entirely. This was a symptom of the heart problem of insufficient demand from consumers and businesses.
A related symptom was the structural shift from the labor market. Where new jobs were created — occasionally, as in the UK, to the extent bringing people back in the workforce — those were focused in low-skilled and low-paid openings in sectors like leisure, hospitality and hospitality. Increased demand for these services was the meagre limit of the”trickle-down” effect from ever-richer asset owners.
All this meant that there wasn’t much real wage growth that, together with related increases in bank lending, is essential for creating inflation. So it was , at the 2010s, monetary policy not merely failed to stimulate the market but actually proved counterproductive. Stimulus along with the pandemic During the pandemic, the situation has been different.
Central banks have been attempting to stimulate the market by expanding QE, but governments also have been using debt-funded spending to substitute for the normal requirement that has disappeared because of the shutdowns. Important governments seem determined to correct the faulty policies of the past decade. This is particularly true of the Biden administration, whose enormous programme of greater spending intends to drive up labor participation and wages — thereby averting the deflationary troubles of the 2010s.
The administration is firmly supported in this by Federal Reserve seat Jerome Powell. Whereas previously, the Fed targeted 2 percent inflation and could increase interest rates in response to reduced unemployment from the belief that inflation could otherwise start rising, it’s now prepared to allow inflation to rise to state 3% in the title of increasing employment to help stimulate economic recovery.
The success of this strategy depends on demand for more workers materialising from US businesses. But critics like Larry Summers, the former Democratic treasury secretary, assert that the government’s monetary stimulus will produce demand beyond the market’s present production capacity, risking persistent inflation.
The big squeezy.
The administration and its supporters counter that there’s more slack in the market compared to people like Summers believe, because so many discouraged workers have fallen out, and greater production of products and services will result from reversing the long dearth of domestic small business investment.
All such happy outcomes will, according to the plan, stream from using government spending to generate demand. The jury remains out on whether this will cause unmanageable inflation — in America or, possibly, in Europe when the ECB, together with the EU and its member countries, follow their clear inclination to emulate the US.
A danger and an opportunity
One points to an opportunity, the other to a danger.
The very first lesson has to do with confidence and the expectations of firms and households, which dominate any conversation about inflation. The 1970s inflation was just really subdued after central banks were granted operational independence from politicians to pursue stable and low inflation. As monetary policy became credible, people no longer anticipated prices to grow so fast. This was the main reason behind the flattening of the Phillips curve — that is, inflation no longer jumps up as unemployment falls.
Put bluntly, policymakers will”get away” with greater stimulus before needing to cover an inflationary cost, and this should improve their likelihood of succeeding.A vital figure in the growth of such thinking about expectations from the 1970s-80s was the American economist Thomas Sargent. His work “systematic changes in inflation policy” also underlies the second — and even more cautionary — lesson for today’s policymakers and the present inflation outlook. In the center of this thinking sits the concept of a government’s budget constraint.
If government spending stimulates requirement to the extent of driving inflation, and monetary policymakers then respond by increasing interest rates, a horrible surprise can ensue. If the government responds by devoting even more money to fund its activities, it could make inflation grow even faster — as the government’s additional spending would end up driving up demand just as the central bank is attempting to curtail it. In other words, a government can simply run so much of a shortage before unexpected problems crop up.
Now this lesson is much more applicable than Sargent and Wallace could have envisioned. These days, rates of interest can no longer be a central bank’s original tool of monetary policy: public and private debt are so large that increasing rates could potentially make repayments unmanageable for many. To take the US as the most notable example, the Fed would rather begin by cutting the degree of government bond purchases moving on to its balance sheet. This bond purchasing has ballooned in the past ten years, especially since governments’ heavy deficit spending throughout the pandemic. The problem is that the money generated through QE ends up, for reasons that don’t need to be explained here, at the reserves of commercial banks held by the central bank.
In the united states, these amounts now approach a fifth of all the Fed’s assets. As and when the Fed decides to”taper” QE — now running at US$120 billion (#85 billion) of purchases per month — just as an initial step in tightening policy to lean against inflation, then this will create a lower proportion of banks’ assets being lodged with the Fed in the kind of reservations, also increase the scope for banks to lend to the real market.
Such credit growth and the related increase in the rate of cash is likely to fuel the inflation pressures that the Fed would like to counter. Since one of the chief goals of QE is to increase bank lending, it’s a paradoxical effect — just like the previous illustration of higher interest rates increasing inflation. The bottom line is that public debt has enlarged to the extent of becoming overvalued in a totally free marketplace. Today’s conundrum made by QE is just the latest demonstration of the truth that ignoring government funding limitations will result, by one way or another, in greater inflation.
The final issue is how all this relates to long-term trends in the labor market and elsewhere. It’s often said that in the past few decades, globalisation and technologies have helped to reduce inflation. Globalisation has kept wages lower by shifting production to poorer states. Technology has made it more economical to make goods and consequently brought prices down, whereas the the gig market has significantly decreased the cost of services. However a recent publication by British-based economists Charles Goodhart and Manoj Pradhan argues that the years ahead will be much less deflationary, for many reasons.
China’s labor market participation is increasing, which is increasing salaries, and baby boomers are retiring, carrying an extremely large generation out of the labor market and making workers more infrequent and therefore more precious. It’s a fascinating debate, but still very debatable. By way of instance, possible inflationary effects of ageing populations might yet be outweighed by the deflationary effect of rapid technological change automating additional tasks. This will reduce workers’ bargaining power and so act as a brake on wage development.
Also, the majority of men and women eat less in retirementand certainly do not borrow too much: the ageing of the baby boomers will consequently be an additional source of deflation.In sum, there’s good reason to expect inflation in the short to medium term, but the longer term picture is much more mixed. The seeds of greater long-term inflation are surely present, however the chances of their germinating depends on a large extent on to what extent the additional financial stimulus from the united states and elsewhere contributes to greater generation, instead of just consumption.
When there’s greater business investment and labor participation, government budget deficits will narrow quicker as the private sector gets back into equipment and pays in taxes. This will also help the Fed to locate a smoother path through the minefield of the depart from QE, since the greater bank lending will be more likely to be unlocking sustainable economic growth.
If so, it’s still possible that the banks’ claims that inflation is only going to be transitory could nevertheless be proven right.
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