Disinflation? More like disappointment.
I’ve long argued on the blog that 2010’s style ultra-loose monetary policy is harmful to the economy, and have predicted on the blog and argued with friends that most central banks in advanced economies are not tough enough to actually get rid of inflation in the near future. When inflation was starting to become a problem last summer I said that the Federal Reserve was negligent in calling it “transitory”, and over the past year more and more people seem to have realised that inflation isn’t a temporary blip but a real problem. Unfortunately, many of those same people take central banks at their word that interest rates will rise at a rapid pace until inflation is back under control. I think they’re wrong.
To be fair, interest rates have been rising faster than many expected, but it’s important to remember what it takes to really quell inflation. For inflation to subside the central bank needs to raise real interest rates, not nominal interest rates. The real interest rate is the nominal (i.e. reported) interest rate minus the rate of inflation. So for a practical example, at the time of writing inflation is 9.1% this year in the US and the Fed funds rate is 1.75% which means that the real interest rate in the US is -7.35%. The Economist reports that the consensus view in the US is that nominal rates will hit 3.5% by the end of the year, which is still far too low to stop inflation. In order to stop inflation in the mid teens Paul Volcker had to raise the nominal rate to over 20% in the early eighties, so rates will probably need to increase to around 10% at least before price increases start accelerating quite so fast; assuming inflation stays at around 9%.
An economy structured around free money can’t handle such a harsh economic climate and central bankers will realise this long before they reach levels of tightening where they have a chance of stopping inflation. Now that the genie is out of the bottle it will take years before the economy has adjusted enough to a high inflation environment that effective disinflation becomes a feasible policy without economic carnage, and it will also take years before policymakers are desperate enough to give someone as determined as Volker the necessary means to disinflate. As I wrote in September last year:
Nearly everything reverts to the mean eventually; let’s hope the central banks revert interest rates to the mean orderly because if they don’t sooner or later the markets will and it’ll be anything but.
This mean reversion is what we’re now facing, and given that the same central bankers who could’ve stopped inflation early but decided that it was “transitory” are still running the show I don’t fancy our prospects of disinflation any time soon.
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I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
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Cover photo by Karolina Grabowska from Pexels, edited by Karl Johansson