Price stability is when people stop talking about inflation and their decisions reflect real economic factors. It had been a long time since inflation was a topic of discussion but, especially in the United States, it has returned to the public debate.
In several advanced economies, it is easy to find evidence of rising input prices and higher commodity prices reflecting shortages. Some of these increases may well turn out to be transitory. For the first time since the 1980s, however, two factors make inflation a serious risk: excessive monetary and fiscal stimulus and weak political resistance to the threat.
In the United States, former Treasury Secretary Larry Summers has argued convincingly that the fiscal stimulus is excessive. Many economists are reluctant to criticize Biden’s stimulus packages because they share his concerns about the country’s social and political problems. But I have seen little challenge to the proposition that the degree of stimulus is out of all proportion to the size of any plausible output gap. And the same logic applies to other advanced economies. The graph below shows the unprecedented quarterly fluctuations in UK production from 2019 to the end of 2021 (using Office for Budget Responsibility forecasts). These fluctuations – by far the largest since reliable statistics began to be collected – reflect economic bottlenecks as the country battles Covid-19.
The graph also shows a second line – for the OBR estimate of potential output over the same period. What’s so striking is that the differences are negligible – the lines move together, reflecting a judgment that the lockdowns affected both demand and supply. This is a sensible point of view shared by the Bank of England. The central bank’s estimate of the output gap is around 1% in the first quarter of 2021, falling to zero in the first quarter of next year. Both find that the output gap at its highest level was no more than about 1% of gross domestic product and is expected to narrow over time.
It is therefore difficult to say that a substantial monetary and fiscal stimulus is necessary. Although Covid-19 has ravaged our economies, its impact has been on both supply and demand. The case for substantial monetary expansion in March 2020 has been presented as a response to “dysfunctional markets”. But the money injection was not withdrawn once the financial markets functioned normally. The stimulus was then justified in terms of “supporting the economy”. The government did need to support the economy, but a substantial monetary stimulus is only appropriate when aggregate demand diverges significantly from aggregate supply.
In 2020 and much of 2021, governments were right to use fiscal policy to prevent a wave of corporate bankruptcies. Many companies suddenly faced with a collapse in demand had a viable future once the pandemic was brought under control. The cost of letting them sink in and reviving them somehow would have been enormous. In Europe, governments have designed leave programs to transfer money from future taxpayers to businesses on the condition that businesses keep jobs. In the United States, support has taken the form of more generous unemployment benefits and subsidies for the industries most affected, such as airlines. The difference between these two approaches can be seen in terms of unemployment. The chart below shows that unemployment in the United States rose sharply from 3.5% to 15% before falling back to its current level of 5.8%. Unemployment in the UK fell from 4% to just 5.1%, before falling back to 4.8%.
There are arguments for and against both approaches. But the key point is that both have provided temporary budget support during lockdowns; these two types of public expenditure additions will be phased out and should be phased out in due course. What is worrying are further increases in public spending funded not by higher taxes but by central bank money creation.
There is another reason to be concerned. Support for monetary policy as a means of combating inflationary risks is diminishing. In the next few years, governments will likely want to spend more, but will not want to raise taxes for most citizens. Higher interest rates or a reduction in central bank balance sheets will make it more difficult for governments to finance their deficits. Inevitably, there will be political pressure on central banks to react slowly to signs of rising inflation.
For their part, the central banks have rather put themselves in a corner, giving the impression that the policy will be relaxed for a long time. The Federal Reserve has been the most explicit on this, but the use of forward guidance by several central banks has been seen as a sign that central banks do not want to toughen their policies for a while. No central bank can know what the appropriate level of interest rates will be a year from now, let alone 2024. Thus, the risk of a slow response to signs of higher inflation or a sharp correction in the currency. market in response to an unexpected tightening – both that would hurt the central bank’s credibility – are real.
The independence of the central bank will be tested over the next few years. And the expansion of central bank mandates into policy areas that are naturally the domain of elected politicians – such as targeting unemployment rates to particular groups in society or using monetary policy tools to fight change. climate – will make the problem worse. It will be more difficult for central banks to disappoint governments, even when controlling inflation makes it necessary.
A combination of political pressures to help finance budget deficits, promises not to tighten policy too soon, and growing central bank involvement in policy issues indicate a growing risk that central banks will react too slowly to inflation. higher.
Few people remember the inflationary experience of the 1970s. But just because inflation isn’t a problem today doesn’t mean it isn’t a risk. In the late 1960s, as a student in Cambridge, England, I remember attending lectures from an old man who warned his audience that creeping inflation was a problem we should take on board. serious. Didn’t he really understand that the Keynesian economy made it possible to combine full employment with low inflation? We ignored it. He was the past and we were the future. This teacher was Richard Kahn, disciple and confidant of John Maynard Keynes, the person credited with inventing the multiplier. It turned out he was right.
We cannot know today whether inflation will increase over the next few years. But the prospect of excessive stimulus and weakened central bank independence should make us nervous.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
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Clive crook at [email protected]