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The speech by Jay Powell, chair of the Federal Reserve, at the Jackson Hole Economic Symposium last month was as close to a paean of victory as a sober central banker could utter. “Inflation has declined significantly,” he noted. “The labour market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalised.” He added that, “With an appropriate dialling back of policy restraint, there is good reason to think that the economy will get back to 2 per cent inflation while maintaining a strong labour market.” So, happy times!
This is a better outcome than I and many others expected two years ago. Indeed, the success in lowering inflation with only a modest weakening of the real economy is a welcome surprise. Unemployment, Powell pointed out, was 4.3 per cent — “still low by historical standards”. In the eurozone and the UK, the outlook is less rosy. But there, too, the prospects are for lower interest rates and stronger demand. As he noted, one of the reasons for this success has been the stability of long-term inflation expectations. That is what the regime of “flexible average inflation targeting” was supposed to achieve. But it is also worth adding that there was some luck, notably over labour supply.
Despite these outcomes, lessons need to be learned, because some of the stories being told about this episode are not right. Mistakes were made in understanding the economics of Covid. Mistakes have also been made in attributing the surge in prices to unexpected supply shocks alone. Demand also played a role. It is highly likely that big supply shocks will happen again, just as there will be further financial crises. Central banks must learn from these experiences even if they believe that this episode ended not too badly.
A big point is that it is more useful to view what has happened as a shock to the overall price level than a jump in inflation rates. Thus, between December 2020 and 2023 the headline consumer price index rose by close to 18 per cent in the US and eurozone, and 21 per cent in the UK. This is very far from the close to 6 per cent that was supposedly the target over three years. No wonder so many recognise a “cost of living crisis”. Moreover, this is a permanent jump. Under inflation targeting these are bygone shocks. This does not mean they will soon be forgotten.
Crucially, temporary shocks to supply do not of themselves cause permanent jumps in the overall price level. Demand must at least accommodate — and is more likely to drive — permanent jumps in prices. In this case, the fiscal and monetary responses to the Covid shock were strongly expansionary. Indeed, the pandemic was treated almost as if it was another great depression. It is no surprise therefore that demand soared as soon as it ended. At the very least, this accommodated the overall effect of price rises in scarce products and services. Arguably, it drove much of the demand that generated those rises.
The British monetarist, Tim Congdon, warned of this, as I noted in May 2020. Think of the famous “equation of exchange” of the American economist Irving Fisher: MV=PT (where M is money, V its velocity of circulation, P the price level and T the volume of transactions). Between the fourth quarters of 2019 and 2020, the ratio of M3 (broad money) to GDP rose by 15 percentage points in the Eurozone, 17 percentage points in the US, 20 percentage points in Japan and 23 percentage points in the UK. This was a global monetary glut. Nothing, Milton Friedman would have said, was more certain than the subsequent “supply shortages” and soaring price levels. Fiscal policy added to the flames. Yes, one cannot steer the economy by money in normal times. But a paper from Bruegel suggests that it is in unsettled conditions that money matters for inflation. The Bank for International Settlements has argued similarly. Thus, big monetary expansions (and contractions) should not be ignored.
This monetary expansion was a one-off: since 2020, the ratios have been allowed to fall back to where they began, as nominal GDP soared. Monetarists would predict that inflation was going to stabilise, as it has. That outcome was helped by stable inflation expectations and, in some places, by immigration.
The fact that the big step jump in price levels was due to the interaction between post-Covid and Ukraine war-induced bottlenecks in supply and strong demand does not mean that the latter was a huge mistake relative to the alternatives. Weaker demand would have imposed large economic and social costs, too. But we need to analyse just such alternatives rigorously, because large shocks are likely to recur.
This past, however, is done. So what now? A big question is whether inflation will in fact stabilise. Another is how far the jump in interest rates will be reversed. Are we in a world in which interest rates will be permanently higher. If so, has fear of the lower bound on interest rates now gone?
The fact that economies have mostly been robust, despite the monetary tightening suggests this could be the case. But that creates a threat to future financial and fiscal stability: new debts will be far more expensive than the old ones. It is plausible that ageing, lower savings rates, fiscal pressures and big investment needs, notably for climate, will combine to make public and private debt consistently more expensive. If so, this potential problem of “high for longer” could prove to be a nightmare.
The inflation-targeting regime has now faced two great tests — the financial crisis and Covid. It has survived both, just about. But more big shocks might come, some of them even quite soon.
martin.wolf@ft.com
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