Complacency led policymakers to misdiagnose inflation

A year ago, inflation appeared under control. Published annual consumer price rises stood at 2 per cent in the eurozone and 2.1 per cent for the UK in May 2021. The 5 per cent figure for the US was higher than normal, but the Federal Reserve dismissed concerns, saying price rises reflected “transitory factors” with chair Jay Powell highlighting lumber and used car prices that were temporarily high and airline and hotel costs that were just climbing back to normal.

What has happened since has surprised all the main advanced economy central banks. The latest published inflation rates stand at 8.6 per cent in the US, 8.1 per cent in the eurozone and 9.1 per cent in the UK. Instead of always blaming something out of their control, central bankers are now taking action.

We should therefore use this moment to take stock. What were the mistakes made in thinking over the past year? And what does this mean for policy and the economic outlook?

Fundamentally, we have rediscovered that resource constraints are real and they matter. With unemployment at multi-decade lows in North America and Europe, there was less scope than after the global financial crisis for households, government or companies to increase spending without generating significant inflationary pressure. Sometimes, of course, resource constraints have also been caused by supply chain bottlenecks, but both represent demand exceeding supply and both are inflationary.

Instead of focusing closely on the constraints, politicians and central bankers placed too much emphasis on the data from after the 2008-09 global financial crisis showing unemployment changes had little impact on wages or prices. Inflation had been low and steady both when joblessness was high and when it came down. Policymakers misdiagnosed this “flat Phillips curve” as a regularity, and that led to complacency. The thinking was that inflation was dead and there were few risks in running a high-pressure economy. We now know this was dangerously wrong.

Central bankers bear particular responsibility in this messy tale. For the past two decades, they convinced themselves the public believed them to be such wonderful price controllers that they could sit back and relax. No company would seek to push prices higher and no worker would seek inflation-busting pay rises because they knew it would be defeated by the central bank.

They believed their credibility was rock solid, so low and stable inflation was a self-fulfilling prophesy. That theory has failed and they are now in a fight to regain public trust. It is not surprising, for example, that net satisfaction with the Bank of England’s inflation management has fallen to its lowest level on record.

The result of these analytical failings and complacency has been the recent rapid rises in interest rates, designed to show central banks are serious about defeating inflation. But this merely brings us to the next problem. All the main models used for managing inflation have been calibrated during a period of price stability and tell us very little about how far to tighten monetary policy when you’ve lost control.

Some of the rise in inflation is still temporary, but much will need to be squeezed from economies without anyone knowing exactly how much pressure to apply. This means the dangers of excessive tightening are as great as continuing to do too little, too late.

In such a difficult world, no one should rule out recessions in the year ahead. The Fed is probably correct to raise interest rates hard, but the truth is that we really don’t know.

Further mistakes in monetary policy are highly likely and we should expect reversals in policy as central banks try to find the right response to a problem they did not think could happen.

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