The United States fears inflation and is fighting it, having previously invoked it and downplayed it. Europe has contracted a milder variant and intends to live with it. But we must consider the risks of stagflation in the medium term.
“For one thing, it was definitely not the plague, absolutely not. The very use of the word was forbidden. Then it was a pestilential fever: the idea was allowed indirectly, with the use of an adjective. And then it was a kind of plague but not the real thing, rather something for which no other name could be found. In the end, it was certainly the plague, but coupled with the idea of poison and witchcraft.” Alessandro Manzoni, The Betrothed, Ch. xxxi
In May 2021 – that recent past which now seems so remote – forecast inflation for the year’s end was 2.7% in the United States. In Europe it was well below 2%. This was the estimate of the Federal Reserve and the average estimate of the major investment houses. And the market wagered on it, because the break-even inflation rate implicit in Treasury securities indexed to inflation was 2.9%. As we now know, that is not how things turned out: seven months later, 2021 ended with the consumer price index above 7% in the US and above 5% in Europe.
Why nobody believed in inflation
Apart from the figures, the most striking thing, looking back at May 2021, is the confident certainty with which the majority defied the few who prophesied a risk of inflation. The most aggressive of the latter – Russell Napier, who in past decades had correctly outlined a structural disinflation scenario and who in 2020 had warned of a radical change of paradigm – still confined his estimate of inflation to 5% for the next year.
The consensus then that inflation was impossible was based on three pillars. And those three pillars were regarded as structural and therefore virtually immutable.
The first related to supply side and innovation. Since progress in computer technology and telecommunications had limited unit costs and increased productivity across almost all sectors of production, the presumption was that widespread robotization and artificial intelligence would do the same, soon producing a surplus of low-cost goods and services.
The second pillar related to the demand side and had to do with demographics. The ageing of the population was no longer confined to Europe and Japan, but was spreading to the Americas and throughout Asia, including China. On the basis of what had happened in Japan, where ageing had coincided with the deflation of the past three decades, the consensus was that the two phenomena were closely connected. Indeed, people make their major purchases – homes first and foremost – in the first half of their lives. In the second half of their lives, people tend to save money to repay their debts, and spend less and less.
The third pillar related to the labor market, giving rise to the certainty that wage pressures were unlikely, even if a recovery were to be driven by ultra-expansive monetary and fiscal policies, and even with a rapid return to full employment. And without wage pressures, an eventual temporary inflation of costs (such as that deriving from increased raw materials prices) would not produce demands for more pay and would soon cease, with no further consequences. This idea was supported by the conviction that the Phillips curve – which links falling numbers of unemployed to increased pay and which had steered monetary policies in the 1960s – was dead and buried. This belief was shared even by the Federal Reserve back in 2019, under Powell. It was also confirmed by the ten years following the Great Recession of 2008, when unemployment fell from 10% to 3% with no impact on wages.
Along with these three structural pillars, there spread a conviction that the central banks would not allow their inflation targets to be exceeded. It is true that precisely during the months preceding the pandemic these targets had been slightly increased, first in America and then in Europe, but 2% – albeit now regarded more flexibly – remained the anchor, as it had stabilized the previous decade so effectively. Indeed, inflation had often remained below target, depriving monetary policy of any leeway.
The problem, it was later realized, is that the central banks’ economic models overestimated the risks of inflation.
If these models – based on a Phillips curve that seemed to have stopped working – had been corrected earlier, the central banks could have allowed the economies to grow more.
The supply factor
On the strength of the aforementioned three pillars and in the conviction that the central banks would not lose control of the situation, economic operators and financial markets responded to the beginnings of inflation in May 2021 very calmly and with an underlying skepticism. The prevalent narrative, partly promoted by the central banks, focused on the theory that price rises were confined to raw materials and to a few other items that had increased anomalously, such as used cars and airfares. As time went by and as inflation continued to grow, the argument – again inspired by the central banks – became that the increases were caused by widespread but temporary problems on the supply side (the shortage of semiconductors, clogged ports, paralyzed production).
Inflation was officially defined as temporary – a narrative that the US Federal Reserve initially qualified and then officially abandoned between October and November.
The Fed was worried about two things. The first was the presence of clear wage inflation. It is true that, though wages were rising they were unable to keep pace with prices, but they did in any case show that they were no longer rigid. The second and potentially even more worrying factor was that wage inflation was helping to limit the labor supply: there was a so-called Great Resignation; 2 million people approaching retirement made their early and final exit from the labor market; many parents with children were forced to stay home because schools were closed. Even if the latter would sooner or later return to the labor market, those who had taken early retirement would not, and neither would those who had enjoyed freedom from work during the past two years and now intended to maintain it.
Be that as it may, it should be noted that pay increases, rather than having been demanded by individual workers or achieved by the trade unions, have almost always been offered unilaterally by employers.
Unable to deal with the demand for their products and experiencing serious difficulties in finding suitable employees, it has been the employers that have upped the pay to entice workers.
This last point leads us to a fundamental consideration. Whereas the official narrative of the central banks and the International Monetary Fund still emphasizes supply problems as the cause of inflationary tensions, no reference is made to surplus demand, stimulated during the pandemic by subsidies and particularly aggressive fiscal incentives. These have been accompanied by monetary stimulation of very negative real rates, which have favored a bubble in financial and property market activities, thus creating a wealth effect and further stimuli to demand.
There are two reasons why the official narrative has nothing to say about demand. On the one hand it disregards what Larry Summers described as a serious policy error: to have created in 2020-2021 a fiscal and monetary remedy (only partly targeted on investments) four times greater than the gap created by the pandemic. And on the other hand, there is the understandable policy not to remedy that error now, by excessively blaming and depressing demand, with the risk of causing a pointless recession for the sake of an immediate return to 2% inflation, come what may.
For that matter, the fact that demand has contributed to inflation together with supply is demonstrated also by Asia. Asian countries have suffered the same increases in raw material prices and the same limitations on supply without any substantial increase in inflation, thanks to its less expansive policies (in China even more so than Japan).
Paradoxically, even the 1970s-type theory put forward in America by President Biden and Senator Warren – whereby the blame for inflation lies with businesses, which have rounded up the price increases suffered higher up the chain – confirms the strength and scale of final demand. Usually, businesses themselves are neither generous nor greedy; rather, they become generous, by sacrificing profit margins, when the demand for their products is weak. They tend to maximize margins when demand is strong.
Next moves for Biden and the Fed
Although inflation is indeed supported on both the supply and demand sides, and while it is true that it is putting down roots that will allow it to continue for the whole decade, it is also likely that we have already witnessed the crest of the wave. If it does not want to yield control of Congress to the Republicans in November, the Biden administration must present voters with an inflation rate at least halved from its peak of 7%. Of course, inflation favors debtors and private debt is high in America. However, the suburban voter who has bought a house with a mortgage is likelier to be a Republican, whereas those who rent their homes because they cannot afford a mortgage and who vote Democrat still go shopping every day and cannot fail to see the rising prices.
To avoid the risk of losing the midterms because of inflation, and despite the return to full employment, the Biden administration and the Fed – whose Democratic leanings have been strengthened by recent appointments – will make a priority of limiting inflation in 2022.
The main means of action will be monetary, with higher interest rates and quantitative tightening, together with a decidedly less buoyant stock market. These measures have a good likelihood of success and should not compromise economic growth trends for the remainder of this year.
The trade-off between inflation and growth from 2023 onward will be a more complicated matter. If, as is likely, economic growth falls still further and if inflation remains above 3%, the Fed will have to choose between abandoning its primary mandate, to limit inflation to 2%, and abandoning its second mandate, full employment. In the event, the Fed will almost certainly opt for inflation stably above its target, but it will pay the price in terms of credibility; it will have to accept the risk that inflation, though still fairly contained, will establish strong roots and become endemic.
Fed’s Mary Daly says it is too early to ‘declare victory’ on inflation fight https://t.co/E517PhEAYI
— Financial Times (@FT) August 11, 2022
The European variant
Compared to America’s, Europe’s inflation displays one critical aspect – a lack of wage inflation. Only in Germany has pay managed to recover some three quarters of the increase in consumer prices. Throughout the rest of the eurozone, the loss of purchasing power has been more evident. Europe, like America, has however returned close to pre-pandemic unemployment levels, a substantial result that is bound to continue improving.
So, in the final analysis, the balance between costs and benefits of the ultra-expansive policies of 2020-2021 has been more favorable in Europe than in America. Indeed, it is mainly Europe that had (and still has) large unused resources to exploit. It is enough to consider the present numbers of unemployed: 4% in America and still 7% in Europe.
It seems clear that in the eurozone, inflation – which, unlike in America, has leaned to the supply side and its bottlenecks rather than to the demand side – is a price which is worth paying, up to a point, for the sake of higher growth.
However, there is one risk that Europe faces more than America: that of green inflation. If the energy transition is unable to accompany falling supplies of fossil fuels with an adequate and simultaneous increase in alternative sources, energy prices will keep rising. If this were to be accompanied by a further migration of energy-intensive industries to jurisdictions that are less sensitive to the decarbonization issue, inflation would be accompanied by lower growth.
Stagflation, which good global growth should succeed in preventing in 2022, will again become a risk from 2023 onward. However, we have time now to work on the bottlenecks in production chains, to adapt the pace and systems of energy transition and to start to normalize monetary and fiscal policies so as to reduce inflation without compromising growth. An orderly escape from the chaos of these past two years of pandemic can only be achieved gradually.
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