On May 4, the United States Federal Reserve raised its benchmark interest rate by half a percentage point in an aggressive attempt to curb surging US annual inflation, which currently stands at a four-decade high of 8.3%. And eurozone inflation reached a record 7.5% year on year in April, according to preliminary estimates.
These sharp, sizeable price increases — accelerated by the war in Ukraine — are raising the spectre of stagflation and may significantly erode households’ purchasing power. Vulnerable lower-income groups are likely to be most severely affected because they have limited access to financial markets, making it difficult for them to smooth their consumption.
Furthermore, because prices increase more for the basic goods that dominate low-income households’ consumption basket, the rich-poor inflation gap — a phenomenon economists call “inflation inequality”— could widen further.
Just a few months ago, the price stability objective was exceptionally low in the growth-inflation trade-off. Central banks, it was argued, should continue to focus on supporting the post-pandemic economic recovery. But now the critical question is whether monetary policymakers are doing enough to fight inflation. In the case of systemically important central banks, it is difficult to argue convincingly that they are considering the risks which have emerged.
For starters, major central banks’ forecasting failures enabled inflation to overshoot their 2% targets and potentially become entrenched. Inflation was trending upward and exceeded official targets on both sides of the Atlantic in the first half of 2021, but officials at the Fed and the European Central Bank stubbornly insisted that faster price growth was transitory.
That view contradicted their own monetary policy rules and was inconsistent with the breakeven inflation rates — in the US, the difference in yield between a nominal treasury security and a treasury inflation-protected security of the same maturity — from implied market expectations. The five-year US breakeven inflation rate is currently about 3% (down from the record high of 3.59% in March 2022), and the Fed’s long-run neutral rate is around 2.4%.
Well-calibrated pre-emptive strikes are often desirable when managing inflation. The risk of wrongly accepting the low-inflation hypothesis and doing too little to prevent the threat from metastasizing greatly outweighs the risk of mistakenly rejecting the null hypothesis of low inflation. This is particularly true when the economy is overheating, because reversing inflationary trends becomes even tougher once inflationary expectations become de-anchored.
But this is precisely where the world now finds itself. Some leading central bankers —as part of their well-intentioned attempts to support the fragile post-pandemic recovery — decided not to pre-empt inflation, or even to respond to current price pressures until they were proven to be persistent.
A succession of shocks over the past few months have sustained the climb of consumer prices. These include supply-chain disruptions and bottlenecks, supply-demand imbalances, semiconductor shortages and rising commodity prices. Upward wage pressures also have played a part, with a tighter labour market feeding through to higher prices, especially in the US.
While some of these shocks are potentially transitory consequences of the pandemic-induced downturn, most have been driven by structural changes, including the deglobalisation process triggered by the US-China trade war. Likewise, supply-chain disruptions — which are estimated to have added one percentage point to core inflation in 2021 — were exacerbated by the pandemic but in fact predated it.
Moreover, the earlier prolonged period of low inflation fuelled the misguided belief that money creation is no longer inflationary. In 1993, then-Fed chair Alan Greenspan argued that the historical relationships between money and income, and between money and the price level, “have largely broken down, depriving the aggregates of much of their usefulness as guides to policy”.
But the current inflation overshoot has perhaps validated Milton Friedman’s famous maxim: “Inflation is always and everywhere a monetary phenomenon.”
© Project Syndicate, 2022
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