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Reasons to think differently about inflation


This article is an on-site version of Martin Sandbu’s Free Lunch newsletter. Sign up here to get the newsletter sent straight to your inbox every Thursday

The summer is upon us! But your favourite newsletter on the global economic policy debate will soldier on. For the next few weeks, I leave Free Lunch in the more than capable care of my colleagues Claire Jones and Chris Cook. Both are acute observers of the economy; I have learnt a lot from them, and I know you will too. I will rejoin you in the second half of August. For now, let me wish all Free Lunch readers a good summer and a restful holiday.

There will be little rest for the inflation debate, however. The numbers keep coming in at record highs. As one of the few people left who believe it is a mistake to try to reduce demand in the economy in response, I leave you with some observations about what worries me in the standard argument. So here are some inconvenient facts and logic in the conventional view for you to consider as you make up your own minds.

First, there is little dispute that at least some of the current inflation is driven by supply but that central banks mostly work on demand. We should all be alert to the danger of motivated reasoning in this situation: it is more comfortable to think that monetary tightening will only slow or reverse “excessive” income and jobs growth. Bringing demand back to “adequate” levels is a more attractive proposition than temporarily depressing our economies below their potential.

But an argument based on demand being “overheated” needs to give a satisfactory account of two important facts. First, the total volume of purchases (real private domestic demand) in the advanced economies is basically right on the pre-pandemic trend. Second, in the US — and only there — the composition of those volumes is hugely lopsided compared with normal times: private goods purchases shot up earlier in the pandemic and remain far above the pre-pandemic trend in the latest available data (the first quarter of this year). A story about inflation being caused by generalised excessive demand does not account well for these facts.

Here, however, is a story that does. Even as overall demand was only coming back to normal levels, the extreme and sustained shift away from services towards goods in the US put strong but sectoral pressure on goods-producing sectors, which because of trade created a global scarcity of tradable goods. This overloaded the global supply chains already out of whack from the pandemic, as shown in soaring shipping rates and clogged ports. It also drove up the prices of inputs into goods production — above all energy and raw materials — and, in time, the prices of final goods themselves. Energy and goods prices later caused cost-driven inflation in service pricing. And, again because goods, energy and commodities are globally traded, the same price pressures soon manifested themselves in the rest of the world as well.

Americans’ sectoral purchase patterns cannot be affected by the Federal Reserve — let alone by other countries’ central banks. So is the policy being pursued one of reducing general demand from adequate to depressed in order to bring US goods purchases back to trend?

Second, it is generally accepted that monetary policy takes time to work — “long and variable lags”, in the jargon. So advocates of tightening must believe that it is appropriate to cool down demand in late 2023 and into 2024, when painful food and energy prices, falling real wages, as well as the withdrawal of pandemic-related fiscal stimulus will have done their contractionary work. Are we risking the economy’s health one or two years down the line because we are unwilling to accept there is nothing we can do about inflation right now? Conversely, is not the wise course of action simply to take inflation today in our stride if there are reasons to think the inflationary supply shocks will subside by themselves?

Third, because the biggest inflationary pressures come from energy prices, the overall inflation rate varies enormously with how fiscal policies are designed to shield energy consumers. Thus, some of the countries with the lowest inflation rates in Europe — such as France, Italy and Norway — are those which have subsidised retail energy prices to keep them below market clearing levels. Much of the debate sounds as if the problem is somehow bigger in countries where inflation is mechanically higher because governments have not adopted below-market price shields. But such policies, however warranted on other grounds, do not affect whether the overall level of demand is excessive (if anything, they boost demand). So any argument that implies a stronger need for monetary tightening because of weaker or no subsidised price caps is suspect.

Fourth, to the extent inflation is indeed driven by energy prices, it is clear what will contain them. That is an expansion of the supply of energy, and in particular zero-carbon electricity in combination with the electrification of energy use, since such electricity sources (especially renewables) tend to have a low marginal cost. But that requires a large upfront investment. Tighter monetary policy makes that harder, not easier. So, as economist Luca Fornaro has shown, there is a conflict between moderating inflation now (by destroying demand) and moderating inflation in the medium to long term (by expanding supply). Even from an exclusive concern for price stability, it is not clear that tightening now is sensible.

Fifth, employment rolls keep expanding. This is one of the brightest aspects of the recovery — even as growth expectations are falling like a rock, our economies keep pulling new workers in from the sidelines. In the past week, we learnt that UK employment rose 0.9 per cent quarter on quarter and US job numbers grew 0.2 per cent month on month. At this rate, they will soon be back at pre-pandemic levels. Even more impressively, the eurozone — the eurozone! — is increasing employment at similar rates, even though it has long since recovered its pre-pandemic jobs numbers.

So what are these “tight” labour markets we keep hearing about? Our economies are still finding extraordinarily large numbers of new workers to employ. A constraint that keeps loosening is no constraint at all. Yet, rather than celebrating these amazing job-creating dynamics, most observers seem to want them to stop, and the sooner the better.

As far as I can tell there is only one answer to all these objections. All the conversations I have had with policymakers, observers and colleagues tended to end up with the dreaded “wage-price spiral” — the worry that even if all my points above are correct, people could come to expect current high inflation to continue, and their behaviour to protect themselves against that will make this a self-fulfilling prophecy. So the “mind games” of convincing workers and businesses that central banks will crack down on inflation come what may must take precedence over the mechanical contractionary effects of monetary tightening.

I have written elsewhere about the problem with fears of wage-price spirals. Here I will just say what the alternative is to this view. It is that despite current inflation, our economies have a very good supply-side story going on, and we would be crazy to try to stop it in its tracks. Rather than slowing our economies, the best cure for inflation would be to keep jobs growth and investment as high as we can.

Taking my — admittedly uncommon — perspective seriously would require us to change how we think about what monetary policy is supposed to achieve.

It means a greater tolerance for supply-driven inflation: rather than trying to undo it from the demand side, let it work through the economy, and do the same when positive supply shocks bring inflation down. And if supply depends on demand — and on investment costs — then we need to look at the longer-term inflation/output trade-off as well as the current one. We may even want central banks to take a role in credit allocation to promote investment (see the paper I recommend on this below).

This could, among other things, mean shifting our focus to stabilise nominal gross domestic product growth, which would leave supply-driven price shocks alone but still counteract demand-driven ones. It would certainly mean greater tolerance for inflationary bursts in inflation — and disinflationary dips. But if the prize is lower inflation and higher output growth on average in the long term, that could be a change for the better.

Other readables

  • In my FT column this week, I lament the decades-old investment drought in advanced economies.

    Line chart of Gross fixed capital investment in per cent of gross domestic product showing Most rich countries have failed to sustain their investment rates
  • My colleagues and I have examined how the confluence of global crises could harm emerging economies. Relatedly, Colombia’s new finance minister has given an interview to the FT.

  • Pessimists have long been worried that the special metals needed for batteries and other products essential for decarbonisation are in limited supply or too dominated by China. But seek and you shall find: cobalt has been found in extraordinary concentration in Australian copper mine waste.

  • Jens van ‘t Klooster cogently sets out the case for central banks to accept a role in credit allocation: the European Central Bank should use its long-term lending to banks to promote lending to climate and energy investments such as energy-efficient housing improvements.

Numbers news

  • Today may be the day when the European Central Bank raises its interest rate for the first time in a decade, and unveils a new instrument to contain sovereign yield spreads.

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