The recent increase in inflation presents a challenge for central banks, but most of all an opportunity.
Over the summer inflation was a popular topic with economists and commentators as central banks across advanced economies presented higher inflation figures than was expected. In many places, like the EU, UK and Canada, these figures were higher but in the US they were genuinely high; the Economist reported as late as the 18th of September that headline prices in America were 5.3% higher in August 2021 than in August 2020. The Economist explains that the increase is partly technical due to the headline price index being less reliable than the Federal Reserve’s preferred index, the personal consumption expenditure index which reported inflation to be closer to 2%. There are other good reasons to think that the headline inflation figure is too high, after all there have been global semiconductor shortages and soaring shipping prices which would naturally drive up prices before these problems are worked out. I personally think there’s a different reason for why inflation has picked up materially in the US and only half-heartedly in the rest of the advanced economies: stimulus checks.The increased inflation is a prime opportunity for the Fed (and other central banks should inflation pick up in other places too) to reverse course and return to a world where borrowing money has a cost.
As I’ve detailed at length on the blog, I’m not a fan of the current accepted monetary policy paradigm. It seems to me as though central banks are complacent and unwilling to critically assess their current policies. The European Central Bank (ECB) is the prime example of a complacent central bank. The ECB has struggled mightily with hitting its 2% per year inflation target the last decade, indeed the average has been 1.3% since January 2008 with four different deflationary periods; though luckily those deflationary episodes have been very short lasting only a few months at most. Why fix a strategy which has led to consistent underperformance for the last 12 years? As for being unwilling to critically assess current policy, the reigning champion is the Bank of Japan (BoJ) which pioneered the strategy of buying financial assets with new money to prevent deflation. The programme started with government bonds but has grown not only in scale but also in scope, notably in 2013 the scope was increased by starting to buy exchange traded funds which follow the TOPIX Japanese stock index. This aggressive policy has yielded a inflation rate which has consistently failed to exceed 1% since 2016. Still, the policy is continued with the BoJ stating on the 22nd of September: ‘The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) as necessary with upper limits of about 12 trillion yen and about 180 billion yen, respectively, on annual paces of increase in their amounts outstanding’ continuing ‘The Bank will purchase CP and corporate bonds with an upper limit on the amount outstanding of about 20 trillion yen in total until the end of March 2022.’ Why fix something that is(n’t) working? You might argue that asset purchasing programmes are the only thing saving Japan from deflation, and you might well be right that the BoJ has successfully staved off deflation but there was a time when the BoJ didn’t need to intervene. Asset purchases have become a crutch and the BoJ seemingly isn’t looking for a way to recover to a point where the Japanese economy can stand on its own two feet. The same is true for the ECB, sure there may have been more deflationary episodes were it not for the ECB, but shouldn’t we have higher expectations? Avoiding deflation shouldn’t be worthy of celebration, it should be the expected minimum..
I mention these shortcomings some of the major central banks have as the increase in inflation in the US could come to end the current monetary policy consensus. As I said earlier in the post I suspect the reason why the US’ inflation is so high is due to the way the US government decided to handle pandemic stimulus. The US drastically increased unemployment benefits to the point where according to Business Insider there were six US states where unemployment benefits were equivalent or higher than 95% of the states’ average weekly wage. Add to that several stimulus checks worth hundreds of dollars and the result is that most consumers could be confident that their standards of living were in no immediate danger and thus could use stimulus money for consumption. In essence, by giving consumers more money the Fed was able to make sure people spent more money. Unsurprisingly this led to an increase in inflation. The Fed insists that the current bout of inflation is transitory i.e. temporary but I personally don’t see it. David Hay argues persuasively in his recently released book excerpts ‘The Anti-Bubble Years’ that the Fed’s rather opaque technical framework for measuring inflation downplays inflation, and further argues that we are likely to see a period of negative real interest rates in the US in the coming years. In other words, Hay argues that inflation will consistently exceed interest rates in the coming years and there are more reasons than those he lists for why that scenario is likely.
A key drawback to ultra low interest rates is it makes borrowing money very appealing and states have made the most of this in the last decade with many public debts exceeding 100% of Gross Domestic Product (GDP). The longer central banks keep interest rates artificially low through asset purchasing the more time governments have to accumulate debt which due to monetary policy is practically free to service. The problem is that the more debt the government takes on the more painful increases to the interest rate becomes which creates powerful incentives to keep interest rates low. As long as inflation is very low this works but if inflation ever picks up then governments face a tough choice: do they let interest rates rise subduing inflation and spend more and more on servicing their debts while slowly paying their debts off, or do they let inflation get ahead of interest rates so that their debts gets reduced faster while causing harm to their citizens and businesses? Right now we are still at a point where there exists a meaningful choice for most advanced economies (except for Japan with a public debt which is over 250% larger than nominal GDP) but if central bankers don’t start to critically assess the path their economies are on we will eventually reach a point where debt burdens would take 50,75, or even 100 years to pay off which would essentially make inflating away the debt the only option.
As I’ve argued before on the blog, current monetary policy is harmful. There needs to be a price to borrowing money to prevent exuberant speculation and asset price bubbles, and while the process of drawing down asset purchasing programmes and raising interest rates above zero could be painful, continuing on the current path of ever-expanding government debts and stock market valuations will prove far more painful in the long run. Inflation is increasing in the US and the Fed should use that as an opportunity to reverse the current path to reach a more normal economic climate. Hay cites an extraordinary figure from Bank of America in the Anti-Bubble Years: current interest rates are at a 5000 year low. Nearly everything reverts to the mean eventually; let’s hope the central banks reverts interest rates to the mean orderly because if they don’t sooner or later the markets will and it’ll be anything but.
If you liked this post you can read my last post about monetary policy here, or the rest of my writings here. It'd mean a lot to me if you recommended the blog to a friend or coworker. Come back next Monday for a new post!
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
Sources:
-Inflation since 2016 p.9
-Quotes referenced p.1
Cover Photo by Karolina Grabowska from Pexels, edited by Karl Johansson
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