The return of inflation is not just an important economic event. It is also a political one. As it becomes decreasingly plausible that it will simply fade painlessly away, tough decisions must be made on how to react to it.
This raises big issues. How did we get here? How large and durable a slowdown will be needed to bring inflation back under control? Is policy tight enough already? If not, what further steps might need to be taken? Not least, should inflation be brought down to previous targets or should policymakers give up and raise their targets instead?
The latest annual report of the Bank for International Settlements provides an excellent analysis of what is happening. More important, it illuminates the dangers in shifting away from the regime of low inflation of the past 40 years.
By April 2022, notes the BIS, “three-quarters of economies were experiencing inflation above 5 per cent. Inflation was back, not as a long-sought friend, but as a threatening foe.”
Indeed, inflation is by now both high and widely spread across countries and sectors. This was at first unexpected and then dismissed as transitory. Neither view has worn well. Inflation is also economically and politically salient. Quite simply, people care about it. Not least, unexpected inflation also means unexpected cuts in real incomes. Unsurprisingly, this is highly unpopular.
Stagflation threat
The danger now is that of stagflation, defined as a prolonged episode of weak growth plus variable and persistent inflation.
To help us understand the nature of this challenge better, the BIS explains the differences between a regime of low inflation and one of high inflation. It does so by looking “under the hood” at how inflation regimes actually work. Crucially, it turns out, inflation behaves differently in these two regimes.
When inflation is durably low, for example, its volatility also falls, as does its persistence: it is self-equilibrating. This is partly because people expect it to stabilise and also because most of the time they just ignore it. The low volatility of inflation is not because of low volatility of individual prices, but of low correlation across them. Relative price changes, even big ones, then have little impact on the general price level.
A regime of high inflation is the opposite. Big shifts in relative prices – large currency depreciation, for example – spread swiftly across the economy, as people struggle to protect themselves against the shocks to real incomes. The mechanism behind this spread is price-price and wage-price spirals. Moreover, the greater the worry, the more pre-emptive efforts become.
Expectations are crucial. When people cease to know what to expect, they become even more urgently defensive.
Explaining away what is happening as due to “exogenous” supply shocks is a big error. What is exogenous to any one economy is often endogenous to all of them. Thus, rapidly expanding demand in a number of significant economies will create a surge in global demand. Third, excess demand will always show up first where prices are flexible, notably in commodities, before spreading.
Crucially, we are now on the cusp of a shift from a low to a high inflation regime. Why has this peril arrived? One explanation was overconfidence in the permanence of low inflation. Another was backward-looking targets of average inflation and overconfidence in the ability to provide forward guidance. Another was ignoring money when, yet again, it mattered. Yet another was overconfidence in supply capacity.
Entrenched shift
Of course, there were also shocks, such as the war.
The more entrenched such a shift in regimes becomes, the greater the costs of reversing it. At worst, it might take a sharp recession or a prolonged slowdown. So far, policymakers have not made this clear. This is also why they are rather likely to give in before they have achieved their goal. It is also why a prolonged stagflation is now quite likely.
An important question then is whether policymakers have done enough to bring inflation down to their targets. The main argument that they have is that financial conditions have tightened sharply already. That is closely related to the rise in financial fragility since the stagflationary episode of the 1970s. At the same time, ratios of broad money to nominal gross domestic product are still at unprecedented levels, while real policy rates remain negative. It is quite possible that policy will have to tighten a great deal further in the months ahead.
Confronted with the need for deeper slowdowns or tighter policy, central banks might flinch. Politicians certainly will.
A possible outcome is a stagflationary cycle, as central banks oscillate between doing too little, reversing, then doing too little again. Another is that many policymakers agree that 2 per cent inflation is too strict. Why not go for 4 per cent or more instead? This would have the benefit of giving central banks more room for downward manoeuvre in interest rates in future, so reducing the need for quantitative easing in subsequent downturns.
The argument is appealing, not least politically, but there are strong objections. Giving up when the going gets tough tells people that policymakers will always give up whenever it gets tough. Furthermore, there is the alternative of using negative policy rates instead. Above all, at say 4 per cent, inflation will be all too evident all the time. In such an inflation-sensitive environment, people will not only find it far harder to separate relative from general price changes, but will just be waiting for the policymakers to deceive them once again.
Money is an essential public good. Sound money underpins political and economic stability: it must not be thrown away. – Copyright The Financial Times Limited 2022
