Central banks’ inflation misstep: easy to criticise, not so simple in reality
When prices first began to climb in the spring of 2021, central banks initially spoke of a temporary shock triggered by the major disconnect between the rapid post-Covid recovery in demand on the one hand and the fact that supply was still constrained by public health restrictions or otherwise unable to cater for surging order books on the other.
At the time, it seemed reasonable to suppose the massive disruption in global supply chains and logistics could be remedied by normalising the conditions of supply, with vaccines coming on stream, and of demand, once catch-up effects had run their course, so that prices would eventually settle down.
However, far from easing, inflationary pressures persisted and even worsened following the outbreak of war in Ukraine as commodity prices – and energy prices in particular – surged afresh, propelling inflation to levels not seen for decades. As what was thought to have been a temporary state of affairs dragged on, central banks, responsible for guaranteeing medium-term price stability, had no choice but to toughen their tone and perform a U-turn by making combating inflation their number one priority. At the turn of the year, Federal Reserve boss Jerome Powell had to hold up his hand and acknowledge this collective misdiagnosis while signalling an aggressive tightening trajectory to prevent the inflation “bump” turning into an tidal wave, even if doing so meant sacrificing growth. Markets somewhat disingenuously welcomed this willingness to face reality: at the time, few had expected inflation to surge so quickly and powerfully. Lawrence Summers, former Treasury Secretary under the Clinton administration and renowned economist, had raised the alarm, warning that Joe Biden’s stimulus plan passed in March 2021 was excessive, with federal transfers to households far exceeding lost income during the Covid crisis, creating a risk that the economy might overheat once public health constraints were lifted. But other reputable economists such as Paul Krugman, drawing on the experience of the 2008 crisis, felt it was better to risk doing too much than too little in an effort to come out of the crisis on top, bearing in mind that, should the economy run too hot and the brakes have to be applied, the Fed would be well equipped and in familiar territory. In the end, the scenario that materialised was the one foreseen by Summers, with the Fed responding in line with Krugman’s recommendations, though Krugman himself was no doubt surprised by just how quickly the inflation genie escaped from the bottle.
With the Fed now determined to banish inflation, the European Central Bank (ECB) is coming under fire for not taking soaring prices seriously enough and waiting too long to kick off its monetary normalisation process. Yet, given the nature of the type of inflation it is supposed to combat, the ECB’s caution does not look unreasonable. In very simple terms, whereas the United States is dealing with a positive demand shock, Europe is faced with a negative supply shock as a direct result of the war in Ukraine, which is hitting the energy sector – gas in particular – as well as the food industry. While the Fed can work to bring down inflation by tightening financing conditions to ease demand, the ECB is powerless to relieve supply-side pressures and act on global commodity prices, with energy and food accounting for 70% of headline inflation. Yet the ECB, still playing for time, has ended up being overtaken by the influence of US monetary policy, with the single currency being battered by the US/Europe interest rate differential. As the euro weakens, heaping inflation on top of inflation, the ECB has resolved to follow in the Fed’s footsteps by stepping up the pace of its rate hikes. Such an increase in pace is not a problem per se provided the goal posts are not moved further away: normalisation should bring interest rates back into neutral territory – admittedly a theoretical concept but nevertheless a compass that has the benefit of indicating the desired direction of monetary policy, in this instance neither accommodative nor restrictive. This signal will no doubt be enough to anchor inflation expectations and safeguard against wage drift. Having called time on the aberration of negative nominal interest rates, we should also see a move back towards having benchmark interest rates that are more closely aligned with the inflationary reality. Going beyond that into restrictive territory looks to be unwarranted in a European economy which, having barely recovered from the shock of the pandemic, is already glimpsing the looming threat of another recession if Russian gas supplies were to be completely shut off – unless the idea is to inflict pointless and avoidable economic harm in the name of monetary orthodoxy.