The writer is head of the BlackRock Investment Institute and former deputy governor of the Bank of Canada
Rising prices hurt everyone. This makes inflation a political hot button. After downplaying the threat initially, central banks are now in a tough spot.
There is a loud chorus of critics with ex-post claims that the inflation threat was there for everyone to see: if only central banks had raised interest rates earlier, we wouldn’t be in this mess. This is unfair. But rather than pushing back on this simplistic narrative, central banks have resorted to sounding ever tougher on inflation.
There is absolutely an urgent need to raise rates back to a neutral level that neither stimulates nor decreases economic activity. The problem: many central banks are now going further and are pledging to stamp out inflation, “whatever it takes”. That appears to be addressing the current politics of inflation. The actual economics of inflation are not that simple — and call for a more nuanced solution.
Inflation today is the manifestation of a deeper regime shift: the end of the “Great Moderation”, the four-decade-long period of reduced growth and inflation volatility. People have long thought this remarkable feat was the result of good policy. Think of the adoption of effective inflation-targeting frameworks and the unprecedented policy moves to avert a second depression in 2008.
There’s an alternative hypothesis. Perhaps it was just good luck. This is the case academics Jim Stock and Mark Watson made to a policymaker audience in Jackson Hole in 2003. Their work suggested the Great Moderation resulted from an economic environment that yielded a more favourable trade-off between fighting inflation and stabilising output. This was met with scepticism then. It now has become clear good luck was a big factor.
From the 1980s until 2020, we were in a demand-driven economy with steadily growing supply. Exuberance and borrowing binges drove overheating, while souring sentiment and collapsing spending drove recessions. Central banks could mitigate both by either raising or cutting rates.
The last two years have been very different. Production constraints have been hampering the economy in ways they never did during the Great Moderation. The pandemic triggered the largest — and still unresolved — spending shift recorded in the US, from services to goods. The most important bottleneck to ramping up production has been labour supply: many people are hesitant to re-enter the labour market or are taking longer to find a job in a new sector. And these production constraints have been exacerbated by large energy and food price shocks resulting from the Ukraine war.
Even when the constraints do resolve, structural trends such as geopolitical fragmentation, the rewiring of globalisation and the climate transition will affect production and push costs up for years to come.
It is possible to bring inflation back to 2 per cent quickly. But this will come at a great cost. Raising interest rates will do nothing to relax these production constraints, reduce energy prices or address the root cause of this inflation. The only way to bring inflation down is to crush the interest-rate sensitive parts of the economy that are not responsible for today’s inflation. This is a far cry from the demand-driven episodes of the last 40 years, when raising interest rates was the remedy for debt-driven spending.
That trade-off is even more complicated given the real risk that inflation becomes entrenched via higher inflation expectations. The only way to deal with that risk? Explain the situation as it is: clearly articulate the very unusual nature of today’s inflation and the stark trade-off it entails. This would help keep inflation expectations anchored. The alternative is damaged credibility for central banks and even more rate hikes.
The bottom line is that the inflation blame-game misses the intricacy of the challenge. An absolutist, “whatever it takes” approach was the right call to stem the financial crisis. It won’t work to rein in today’s inflation.
We are facing the starkest trade-off between inflation and growth since the early 1980s. Central banks will have to crush the economy to kill inflation. Or we might be forced to live with more inflation. This is not a trivial choice. Either way, we are on course for a less favourable combination of inflation and growth. Blindly pursuing the politics of inflation is almost certain to lead to even worse outcomes. A clear and nuanced framing of the issue is difficult to achieve in today’s hyper-politicised environment, but it’s what we badly need.
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