Four tests that tell me inflation is here to stay
Wednesday’s inflation numbers made matters worse for a Bank of England that, frankly, has had a poor record of late. At 10.1 per cent, consumer prices rose at a double-digit rate for the seventh consecutive month. The widely anticipated benefits of lower energy price inflation were mostly offset by hefty increases in food prices and a range of increasingly costly leisure activities. Meanwhile, although wages are rising a lot more slowly than prices, they’re nevertheless rising fast enough to suggest that inflation is becoming properly embedded.
We are, thus, a long way away from both the Bank’s and the government’s ambitions regarding price stability. Earlier this year, Rishi Sunak promised to halve the inflation rate, a frankly limited commitment given where we currently are. The Bank, meanwhile, continues to forecast an eventual drop in inflation to below 2 per cent, even though upside surprises to date have forced the Bank’s Monetary Policy Committee to raise the key policy rate on multiple occasions.
Another way of thinking about the Bank’s inflationary challenge is to argue that the “costs” of achieving price stability have gone up. For the first time in decades, monetary policy is having to do some serious heavy lifting.
Yet too many policymakers prefer to blame inflation primarily on what might loosely be described as “external shocks”: developments over which they have no direct control. The implication is that inflation can be “self-correcting”. On this rather blinkered view, monetary policy can only do so much.
One version of this self-correcting argument is that higher energy prices (and food prices) push overall prices up relative to wages, leading to a real wage “squeeze” that will lead to a natural slowing of economic growth, in the process truncating any inflationary risk.
This view can be summarised in two quotes: “To a considerable extent ... inflation has been the consequence of costs and prices imported from abroad and over which we have no control”, and “the consequence of the staggering increase in [energy] prices at present will be to depress consumer demand”.
Yet these words were uttered by Anthony Barber, the then-chancellor, in early 1974. “Excusing” inflation is all very well but, as Barber discovered, excuses alone are no way to tackle inflation. It is, after all, a profoundly unfair process, redistributing income and wealth in entirely undemocratic ways. History tells us, time after time, that those who have “pricing power” will seek compensation for inflationary traumas, in the process throwing more fuel on the inflationary fire.
How did central banks end up in this alarming position? In my new book, We Need to Talk About Inflation: 14 Urgent Lessons from the Last 2000 Years, I offer four tests to gauge whether inflation is in danger of becoming embedded. My tests are less about forecasting — which is a mug’s game at the best of times — and more about how inflation can become re-established after a period of relative tranquillity.
My first test is simple. Have there been institutional changes creating a bias in favour of inflation? In recent years, the answer is “yes”. In 2020, the US Federal Reserve adopted a “flexible average inflation target” (FAIT) when it thought deflation, a world of falling prices, was the bigger danger. The move came too late: the seeds had already been sown for a period of rapidly rising inflation. Yet the Fed carried on worrying about the last deflationary war, suggesting, initially, a degree of inflationary indifference.
Meanwhile, the persistent use of quantitative easing meant that government bond markets were increasingly being “nationalised” (for want of a better word). Historically, bond markets acted as a rather useful early warning system for future inflation: yields would typically rise in anticipation of an inflationary threat. This time, yields rose only when higher inflation was already an unfortunate reality. The financial “radar system” had been turned off.
The second test is evidence of monetary excess. You don’t have to be a monetarist to recognise that “printing” a huge amount of extra money is likely to lead to higher prices. That’s exactly what central bankers did in the early stages of the pandemic. Most of them, however, shrugged their shoulders and concluded “nothing to see here”. Monetarism was out of fashion. Bizarrely, in central banking corridors, so too was monitoring the money supply.
The third test is to see whether inflationary risks are being trivialised, consistent with the Barber approach of the 1970s. One variant of this is the treatment of “two-year ahead” inflation forecasts made by central banks. The table below shows the Bank of England’s record in recent years. Over time, the “current” inflation rate has risen and so, too, has the Bank’s “one-year ahead” inflation forecast. The “two-year ahead” forecast, however, has consistently been either at, or below, the Bank’s 2 per cent target. Apparently, the Bank believes that, in the medium term, all is for the best in the best of all monetary worlds. History suggests that it’s a worryingly complacent approach.
The fourth test is to assess whether supply conditions have changed for the worse. Post-pandemic, many people have opted for early retirement, others have chosen to work part-time from home, and both companies and governments are thinking about “nearshoring” or “reshoring” to escape from the fragility of global supply chains.
These developments are an extension of changes that were already under way. The deteriorating relationship between the US and China was pointing to a moderation of hyper-globalisation, the overriding narrative for decades. Pitiful productivity performance had lowered the “speed limits” for economic growth. Yes, inflation was still well-behaved. The policy risk, however, was already established. Offering too much stimulus when economic capacity was limited was likely to end in inflationary tears. And so it has proved.
Central bank thinking on inflation has simply become too blinkered. Armed with my four tests, it’s possible to tease out the risks to what remains a cosy forecasting consensus. Either monetary policy may have to be tightened further than people expect or we’ll have to get used to a world in which inflation is persistently higher than existing central bank targets, with a whole bunch of additional volatility to boot.
The chances of central banks daring to forecast such outcomes is, however, low. As such, faith in our monetary masters is likely to come under pressure in the months and years ahead.
PS
Central bank independence has been regarded as the best way of establishing monetary credibility and low and stable inflation. Politicians were always tempted by the monetary printing press. Central banking technocrats, in contrast, would always be able to look beyond the next election, setting interest rates in ways that would offer price stability over the medium term.
Such independence was worshipped in some countries. The folk memories of hyperinflation from the Weimar era left most Germans content to give the Bundesbank sweeping monetary powers. Not all countries have had such hideous experiences and many central banks gained their independence only when inflation was under control. The Bank of England is a case in point.
What happens, however, if a previously untested central bank is confronted with inflation rates in a return to the “bad old days”? Do technocrats really have the power to throw an economy into a deep recession in a bid to bring inflation under control?
Margaret Thatcher was deeply unpopular among many in the UK in the early 1980s when dealing with inflation, but at least she could claim political legitimacy for her painful policies: she was re-elected in 1983 and again in 1987. Could central bankers claim the same today? It seems unlikely. Politicians looking for scapegoats for poor economic performance will be tempted to blame their central bankers. Perhaps the golden era of all-powerful central banking titans is drawing to a close.
Stephen King (@kingeconomist) is HSBC’s senior economic adviser and author of We Need to Talk About Inflation (Yale)
No comments:
Post a Comment