The Deficit Myth: The Biggest Lie in Politics

 

Economists draw swords over how to tackle Inflation

For as long as inflation has been high economists have fought about where it came from and what must be done to bring it down. Since central bankers have raised interest rates and headline inflation is falling, this debate may seem increasingly academic. In fact, it is increasingly important. Inflation is falling mostly because energy prices are down, a trend that will not last for ever. Underlying or “core” inflation is more stubborn (see chart 1). History suggests that even a small amount of sticky underlying inflation is hard to dislodge.




So the chiefs of the world’s most important central banks are now warning that their job is far from done. “Getting inflation back down to 2% has a long way to go,” said Jerome Powell, chairman of the Federal Reserve, on June 29th. “We cannot waver, and we cannot declare victory,” Christine Lagarde, president of the European Central Bank, told a meeting of central bankers in Portugal just two days earlier. Andrew Bailey, governor of the Bank of England, recently said that interest rates will probably stay higher than markets expect.

This means there will be no let-up in the economists’ wars. The first front is partly ideological, and concerns who should shoulder the blame for rising prices. An unconventional but popular theory suggests greedy firms are at fault. This idea first emerged in America in mid-2021, when profit margins for non-financial companies were unusually strong and inflation was taking off. It is now gaining a second wind, propelled by the imf, which recently found that rising profits “account for almost half the increase” in euro-zone inflation over the past two years. Ms Lagarde appears to be entertaining the thesis, too, telling the European Parliament that “certain sectors” had “taken advantage” of the economic turmoil, and that “it’s important that competition authorities could actually look at those behaviours.”

Greedflation is a comforting idea for left-leaning types who think the blame for inflation is too often pinned on workers. Yet it would be strange to think firms suddenly became more greedy, making prices accelerate. Inflation is caused by demand exceeding supply—something that offers plentiful profit opportunities. The greedflation thesis “muddles inflation’s symptoms with its cause”, according to Neil Shearing of Capital Economics, a consultancy. Wages have tended to play catch-up with prices, not vice versa, because, as the imf’s economists note, “wages are slower than prices to react to shocks”. That is a crucial lesson from today’s inflationary episode for those who always view economic stimulus as being pro-worker.

The second front in the inflation wars concerns geography. America’s inflation was at first more homegrown than the euro zone’s. Uncle Sam spent 26% of gdp on fiscal stimulus during covid-19, compared with 8-15% in Europe’s big economies. And Europe faced a worse energy shock than America after Russia invaded Ukraine, both because of its dependence on Russian natural gas and the greater share of its income that goes on energy. A recent paper by Pierre-Olivier Gourinchas, chief economist at the imf, and colleagues attributes just 6% of the euro zone’s underlying inflation surge to economic overheating, compared with 80% of America’s.

This implies that Europe can get away with looser policy. The 3% of gdp of extra fiscal stimulus the euro zone has recently unleashed by subsidising energy bills, the authors find, has not contributed to overheating, and by reducing measured energy prices may even have stopped an inflationary mindset from taking hold. (The authors caution that things might have been different had energy prices not fallen, reducing the subsidy.) Interest rates are lower in Europe, too. Financial markets expect them to peak at around 4% in the euro zone, compared with 5.5% in America.


Despite all this, inflation problems on each side of the Atlantic actually seem to be becoming more alike over time. In both places, inflation is increasingly driven by the price of local services, rather than food and energy (see chart 2). The pattern suggests that price rises in both places are being driven by strong domestic spending. Calculated on a comparable basis, core inflation is higher in the euro zone. So is wage growth. According to trackers produced by Goldman Sachs, a bank, wages are growing at an annualised pace of 4-4.5% in America, and nearly 5.5% in the euro area.

Hence the importance of a final front: the labour market. Even if profit margins fall, central banks cannot hit their 2% inflation targets on a sustained basis without the demand for and supply of workers coming into better balance. Last year economists debated whether in America this required a higher unemployment rate. Chris Waller of the Fed said no: it was plausible job vacancies, which had been unusually high, could fall instead. Olivier Blanchard, Alex Domash and Lawrence Summers were more pessimistic. In past economic cycles, they pointed out, vacancies fell only as unemployment rose. Since then Mr Waller’s vision has in part materialised. Vacancies have fallen enough that, according to Goldman, the rebalancing of the labour market is three-quarters complete. Unemployment remains remarkably low, at 3.7%.

Yet the process seems to have stalled of late (fresh data were due to be released as we published this article). Mr Blanchard and Ben Bernanke, a former Fed chairman, recently estimated that, given the most recent relationship between vacancies and joblessness, getting inflation to the Fed’s target would require the unemployment rate to exceed 4.3% for “a period of time”. Luca Gagliardone and Mark Gertler, two economists, reckon that unemployment might rise to 5.5% in 2024, resulting in inflation dropping to 3% in a year and then falling towards 2% “at a very slow pace”.

Rises in unemployment of such a size are not enormous, but in the past have typically been associated with recessions. Meanwhile, in the euro zone, vacancies have not been particularly elevated relative to unemployment, making the route to a painless disinflation even more difficult to see. It is this front of the inflation wars which is most finely poised—and where the stakes are highest.

A dispatch from the intellectual battlefield in The Economist

Economics Essay 36: Advantage/Disadvantage of joining the Euro

Discuss the possible benefits and drawbacks to EU member countries of adopting the euro.

The adoption of the euro by EU member countries has both benefits and drawbacks. Let's explore them with examples:

Benefits:

1. Price stability: Countries like Germany and the Netherlands, which adopted the euro, have experienced relatively low inflation rates compared to their pre-euro periods. This has provided a stable price environment, benefiting businesses and consumers.

2. Enhanced trade and investment: For countries like Ireland and Spain, joining the eurozone has facilitated increased trade and investment. They have attracted foreign direct investment and witnessed a surge in exports, taking advantage of the seamless trade within the eurozone.

3. Increased credibility and market access: Countries such as Estonia and Slovenia, after joining the eurozone, have witnessed increased investor confidence and improved access to international capital markets. This has allowed them to borrow at lower interest rates and reduce their borrowing costs.

Drawbacks:

1. Limited flexibility during economic crises: Greece faced significant challenges during the global financial crisis, as it couldn't devalue its currency to regain competitiveness. The lack of exchange rate flexibility constrained its ability to address economic imbalances and required external assistance.

2. Asymmetric impacts during economic shocks: The sovereign debt crisis in the eurozone highlighted the challenges faced by countries like Greece, Portugal, and Spain. They experienced severe economic downturns and had limited policy options to address the crisis due to the constraints imposed by the eurozone framework.

3. Loss of seigniorage: For countries like Italy and France, joining the eurozone resulted in the loss of seigniorage revenue. They no longer had the ability to earn profits from issuing their own currency, which could have been used to fund government programs or reduce public debt.

4. Fiscal coordination challenges: The eurozone requires adherence to fiscal rules to maintain stability. Countries like Italy and Spain have faced challenges in meeting deficit and debt targets, requiring them to implement austerity measures and adjust their fiscal policies to comply with eurozone regulations.

5. Differential competitiveness: Countries with structural differences, such as Germany and Greece, face varying levels of competitiveness within the eurozone. The inability to adjust exchange rates can lead to divergent economic performance, with some countries struggling to maintain competitiveness and achieve balanced economic growth.

These examples illustrate the diverse experiences of different countries within the eurozone, reflecting both the benefits and challenges associated with adopting the euro. It is important for each country to carefully consider their specific circumstances and weigh the potential benefits against the drawbacks before making a decision to join the eurozone.

Economics Essay 30: Quantitative Easing

 Discuss whether a reversal of QE is likely to be economically beneficial.

Quantitative Easing (QE) is an unconventional monetary policy tool used by central banks to stimulate the economy when traditional monetary policy measures, such as lowering interest rates, are insufficient. It involves the central bank purchasing government bonds or other financial assets from commercial banks and injecting liquidity into the economy. The goal of QE is to lower borrowing costs, increase lending, and encourage spending to stimulate economic growth.

When evaluating the potential economic benefits of reversing QE, several factors need to be considered:

1. Economic Growth: Reversing QE has the potential to impact economic growth. As liquidity is withdrawn from the economy, it may lead to tighter financial conditions, higher borrowing costs, and reduced consumer and business spending. This could result in a slowdown in economic growth or even a contraction in some cases.

2. Unemployment: The impact of reversing QE on unemployment is complex and depends on the specific circumstances. Tightening liquidity may lead to reduced business investment and hiring, potentially leading to job losses. However, if reversing QE is undertaken to control inflationary pressures, it can help maintain price stability, which in turn can support long-term economic growth and employment stability.

3. Inflation: Reversing QE can be used as a tool to control inflationary pressures in the economy. If the central bank perceives that inflation is becoming a concern due to excessive money supply, reversing QE can help tighten monetary policy and prevent inflation from spiraling out of control. This can contribute to price stability and maintain the purchasing power of consumers.

4. Balance of Payments: Reversing QE may have implications for a country's balance of payments. As liquidity is withdrawn from the economy, it could result in a stronger domestic currency, which may impact export competitiveness. A stronger currency can make exports relatively more expensive and imports cheaper, potentially leading to a deterioration in the trade balance and a higher current account deficit.

5. Financial Markets: The reversal of QE can have significant impacts on financial markets. Selling off large amounts of assets acquired through QE may lead to market disruptions and increased volatility. Investors and market participants may need to adjust their investment strategies and asset allocations in response to the changing liquidity conditions, which could impact asset prices and overall market stability.

6. Confidence and Expectations: Reversing QE requires clear and effective communication from the central bank to manage market expectations. Changes in monetary policy can influence investor and consumer confidence. If the central bank successfully conveys a sense of stability and a well-managed transition, it can help maintain confidence in the economy and minimize disruptions.

It's important to note that the effects of reversing QE can vary depending on the specific economic conditions, the timing and pace of the reversal, and the effectiveness of the central bank's communication and policy implementation. Careful assessment and consideration of the potential impacts on growth, unemployment, inflation, balance of payments, and financial markets are necessary to ensure that the benefits outweigh any potential drawbacks.

While the reversal of QE may help address inflationary pressures and promote long-term economic stability, it also carries potential risks. The withdrawal of liquidity can tighten financial conditions, leading to slower economic growth and potential job losses. Additionally, the impact on financial markets and investor confidence should be closely monitored to mitigate any disruptions.

Furthermore, free market fundamentalists argue that the market should be left to correct itself without excessive government intervention, including unconventional monetary policies like QE. They believe that market forces should determine interest rates, asset prices, and economic growth without central bank intervention.

In conclusion, the reversal of QE should be carefully evaluated, taking into account its potential impacts on economic growth, unemployment, inflation, balance of payments, and financial markets. The timing, pace, and communication of the reversal are crucial to managing market expectations and minimizing disruptions. While QE can provide short-term stimulus, its long-term effects and potential risks should be carefully considered in the context of specific economic conditions.

After the easy money: a giant stress test for the financial system

John Plender in The FT 

Five weeks after the collapse of Silicon Valley Bank, there is no consensus on whether the ensuing financial stress in North America and Europe has run its course or is a foretaste of worse to come. 

Equally pressing is the question of whether, against the backdrop of still high inflation, central banks in advanced economies will soon row back from monetary tightening and pivot towards easing. 

These questions, which are of overwhelming importance for investors, savers and mortgage borrowers, are closely related. For if banks and other financial institutions face liquidity crises when inflation is substantially above the central banks’ target, usually of about 2 per cent, acute tension arises between their twin objectives of price stability and financial stability. In the case of the US Federal Reserve, the price stability objective also conflicts with the goal of maximum employment. 

The choices made by central banks will have a far-reaching impact on our personal finances. If inflation stays higher for longer, there will be further pain for those who have invested in supposedly safe bonds for their retirement. If the central banks fail to engineer a soft landing for the economy, investors in risk assets such as equities will be on the rack. And for homeowners looking to refinance their loans over the coming months, any further tightening by the Bank of England will feed into mortgage costs. 

The bubble bursts 

SVB, the 16th largest bank in the US, perfectly illustrates how the central banks’ inflation and financial stability objectives are potentially in conflict. It had been deluged with mainly uninsured deposits — deposits above the official $250,000 insurance ceiling — that far exceeded lending opportunities in its tech industry stamping ground. So it invested the money in medium and long-dated Treasury and agency securities. It did so without hedging against interest rate risk in what was the greatest bond market bubble in history. 

The very sharp rise in policy rates over the past year pricked the bubble, so depressing the value of long-dated bonds. This would not have been a problem if depositors retained confidence in the bank so that it could hold the securities to maturity. Yet, in practice, rich but nervous uninsured depositors worried that SVB was potentially insolvent if the securities were marked to market. 

 An inept speech by chief executive Greg Becker on March 9 quickly spread across the internet, causing a quarter of the bank’s deposit base to flee in less than a day and pushing SVB into forced sales of bonds at huge losses. The collapse of confidence soon extended to Signature Bank in New York, which was overextended in property and increasingly involved in crypto assets. Some 90 per cent of its deposits were uninsured, compared with 88 per cent at SVB. 

Fear spread to Europe, where failures of risk management and a series of scandals at Credit Suisse caused deposits to ebb away. The Swiss authorities quickly brokered a takeover by arch rival UBS, while in the UK the Bank of England secured a takeover of SVB’s troubled UK subsidiary by HSBC for £1. 

These banks do not appear to constitute a homogeneous group. Yet, in their different ways, they demonstrate how the long period of super-low interest rates since the great financial crisis of 2007-09 introduced fragilities into the financial system while creating asset bubbles. As Jon Danielsson and Charles Goodhart of the London School of Economics point out, the longer monetary policy stayed lax, the more systemic risk increased, along with a growing dependence on money creation and low rates. 

The ultimate consequence was to undermine financial stability. Putting that right would require an increase in the capital base of the banking system. Yet, as Danielsson and Goodhart indicate, increasing capital requirements when the economy is doing poorly, as it is now, is conducive to recession because it reduces banks’ lending capacity. So we are back to the policy tensions outlined earlier. 

Part of the problem of such protracted lax policy was that it bred complacency. Many banks that are now struggling with rising interest rates had assumed, like SVB, that interest rates would remain low indefinitely and that central banks would always come to the rescue. The Federal Deposit Insurance Corporation estimates that US banks’ unrealised losses on securities were $620bn at the end of 2022. 

A more direct consequence, noted by academics Raghuram Rajan and Viral Acharya, respectively former governor and deputy governor of the Reserve Bank of India, is that the central banks’ quantitative easing since the financial crisis, whereby they bought securities in bulk from the markets, drove an expansion of banks’ balance sheets and stuffed them with flighty uninsured deposits. 

Rajan and Acharya add that supervisors in the US did not subject all banks to the same level of scrutiny and stress testing that they applied to the largest institutions. So these differential standards may have caused a migration of risky commercial real estate loans from larger, better-capitalised banks to weakly capitalised small and midsized banks. There are grounds for thinking that this may be less of an issue in the UK, as we shall see. 

A further vulnerability in the system relates to the grotesque misallocation of capital arising not only from the bubble-creating propensity of lax monetary policy but from ultra-low interest rates keeping unprofitable “zombie” companies alive. The extra production capacity that this kept in place exerted downward pressure on prices. 

Today’s tighter policy, the most draconian tightening in four decades in the advanced economies with the notable exception of Japan, will wipe out much of the zombie population, thereby restricting supply and adding to inflationary impetus. Note that the total number of company insolvencies registered in the UK in 2022 was the highest since 2009 and 57 per cent higher than 2021. 

A system under strain  

In effect, the shift from quantitative easing to quantitative tightening and sharply increased interest rates has imposed a gigantic stress test on both the financial system and the wider economy. What makes the test especially stressful is the huge increase in debt that was encouraged by years of easy money. 

William White, former chief economist at the Bank for International Settlements and one of the few premier league economists to foresee the great financial crisis, says ultra easy money “encouraged people to take out debt to do dumb things”. The result is that the combined debt of households, companies and governments in relation to gross domestic product has risen to levels never before seen in peacetime. 

All this suggests a huge increase in the scope for accidents in the financial system. And while the upsets of the past few weeks have raised serious questions about the effectiveness of bank regulation and supervision, there is one respect in which the regulatory response to the great financial crisis has been highly effective. It has caused much traditional banking activity to migrate to the non-bank financial sector, including hedge funds, money market funds, pensions funds and other institutions that are much less transparent than the regulated banking sector and thus capable of springing nasty systemic surprises. 

An illustration of this came in the UK last September following the announcement by Liz Truss’s government of unfunded tax cuts in its “mini” Budget. It sparked a rapid and unprecedented increase in long-dated gilt yields and a consequent fall in prices. This exposed vulnerabilities in liability-driven investment funds in which many pension funds had invested in order to hedge interest rate risk and inflation risk. 

Such LDI funds invested in assets, mainly gilts and derivatives, that generated cash flows that were timed to match the incidence of pension outgoings. Much of the activity was fuelled by borrowing. 

UK defined-benefit pension funds, where pensions are related to final or career average pay, have a near-uniform commitment to liability matching. This led to overconcentration at the long end of both the fixed-interest and index-linked gilt market, thereby exacerbating the severe repricing in gilts after the announcement. There followed a savage spiral of collateral calls and forced gilt sales that destabilised a market at the core of the British financial system, posing a devastating risk to financial stability and the retirement savings of millions. 

This was not entirely unforeseen by the regulators, who had run stress tests to see whether the LDI funds could secure enough liquidity from their pension fund clients to meet margin calls in difficult circumstances. But they did not allow for such an extreme swing in gilt yields. 

Worried that this could lead to an unwarranted tightening of financing conditions and a reduction in the flow of credit to households and businesses, the BoE stepped in to the market with a temporary programme of gilt purchases. The purpose was to give LDI funds time to build their resilience and encourage stronger buffers to cope with future volatility in the gilts market. 

The intervention was highly successful in terms of stabilising the market. Yet, by expanding its balance sheet when it was committed to balance sheet shrinkage in the interest of normalising interest rates and curbing inflation, the BoE planted seeds of doubt in the minds of some market participants. Would financial stability always trump the central bank’s commitment to deliver on price stability? And what further dramatic repricing incidents could prompt dangerous systemic shocks? 

Inflation before all? 

The most obvious scope for sharp repricing relates to market expectations about inflation. In the short term, inflation is set to fall as global price pressures fall back and supply chain disruption is easing, especially now China continues to reopen after Covid-19 lockdowns. The BoE Monetary Policy Committee’s central projection is for consumer price inflation to fall from 9.7 per cent in the first quarter of 2023 to just under 4 per cent in the fourth quarter. 

The support offered by the Fed and other central banks to ailing financial institutions leaves room for a little more policy tightening and the strong possibility that this will pave the way for disinflation and recession. The point was underlined this week by the IMF, which warned that “the chances of a hard landing” for the global economy had risen sharply if high inflation persists. 

Yet, in addition to the question mark over central banks’ readiness to prioritise fighting inflation over financial stability, there are longer-run concerns about negative supply shocks that could keep upward pressure on inflation beyond current market expectations, according to White. For a start, Covid-19 and geopolitical friction are forcing companies to restructure supply lines, increasing resilience but reducing efficiency. The supply of workers has been hit by deaths and long Covid. 

White expects the production of fossil fuels and metals to suffer from recently low levels of investment, especially given the long lags in bringing new production on stream. He also argues that markets underestimate the inflationary impact of climate change and, most importantly, the global supply of workers is in sharp decline, pushing up wage costs everywhere. 

Where does the UK stand in all this? The resilience of the banking sector has been greatly strengthened since the financial crisis of 2007-08, with the loan-to-deposit ratios of big UK banks falling from 120 per cent in 2008 to 75 per cent in the fourth quarter of 2022. Much more of the UK banks’ bond portfolios are marked to market for regulatory and accounting purposes than in the US. 

The strength of sterling since the departure of the Truss government means the UK’s longstanding external balance sheet risk — its dependence on what former BoE governor Mark Carney called “the kindness of strangers” — has diminished somewhat. Yet huge uncertainties remain as interest rates look set to take one last upward step. 

Risks for borrowers and investors 

For mortgage borrowers, the picture is mixed. The BoE’s Financial Policy Committee estimates that half the UK’s 4mn owner-occupier mortgages will be exposed to rate rises in 2023. But, in its latest report in March, the BoE’s FPC says its worries about the affordability of mortgage payments have lessened because of falling energy prices and the better outlook for employment. 

The continuing high level of inflation is reducing the real value of mortgage debt. And, if financial stability concerns cause the BoE to stretch out the period over which it brings inflation back to its 2 per cent target, the real burden of debt will be further eroded. 

For investors, the possibility — I would say probability — that inflationary pressures are now greater than they have been for decades raises a red flag, at least over the medium and long term, for fixed-rate bonds. And, for private investors, index-linked bonds offer no protection unless held to maturity. 

That is a huge assumption given the unknown timing of mortality and the possibility of bills for care in old age that may require investments to be liquidated. Note that the return on index-linked gilts in 2022 was minus 38 per cent, according to consultants LCP. When fixed-rate bond yields rise and prices fall, index-linked yields are pulled up by the same powerful tide. 

Of course, in asset allocation there can be no absolute imperatives. It is worth recounting the experience in the 1970s of George Ross Goobey, founder of the so-called “cult of the equity” in the days when most pension funds invested exclusively in gilts. 

While running the Imperial Tobacco pension fund after the war he famously sold all the fund’s fixed-interest securities and invested exclusively in equities — with outstanding results. Yet, in 1974, he put a huge bet on “War Loan” when it was yielding 17 per cent and made a killing. If the price is right, even fixed-interest IOUs can be a bargain in a period of rip-roaring inflation. 

A final question raised by the banking stresses of recent weeks is whether it is ever worth investing in banks. In a recent FT Money article, Terry Smith, chief executive of Fundsmith and a former top-rated bank analyst, says not. He never invests in anything that requires leverage (or borrowing) to make an adequate return, as is true of banks. The returns in banking are poor, anyway. And, even when a bank is well run, it can be destroyed by a systemic panic. 

Smith adds that technology is supplanting traditional banking. And, he asks rhetorically, have you noticed that your local bank branch has become a PizzaExpress, in which role, by the way, it makes more money? 

 A salutary envoi to the tale of the latest spate of bank failures. 

Raising interest rates to tame inflation will only cause more pain

Central banks are set on a path to cause recession – and marginalised people will pay the price writes Joseph Stiglitz in The Guardian

Higher interest rates will not do what people need, such as lower the price of food. 



Central banks’ unwavering determination to increase interest rates is truly remarkable. In the name of taming inflation, they have deliberately set themselves on a path to cause a recession – or to worsen it if it comes anyway. Moreover, they openly acknowledge the pain their policies will cause, even if they don’t emphasise that it is the poor and marginalised, not their friends on Wall Street, who will bear the brunt of it. And in the US, this pain will disproportionately befall people of colour.

As a new Roosevelt Institute report that I co-authored shows, any benefits from the extra interest rate-driven reduction in inflation will be minimal, compared with what would have happened anyway. Inflation already appears to be easing. It may be moderating more slowly than optimists hoped a year ago – before Russia’s war in Ukraine – but it is moderating nonetheless, and for the same reasons that optimists had outlined. For example, high auto prices, caused by a shortage of computer chips, would come down as the bottlenecks were resolved. That has been happening, and car inventories have indeed been rising.

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Optimists also expected oil prices to decrease, rather than continuing to increase; that, too, is precisely what has happened. In fact, the declining cost of renewables implies that the long-run price of oil will fall even lower than today’s price. It is a shame that we didn’t move to renewables earlier. We would have been much better insulated from the vagaries of fossil fuel prices, and far less vulnerable to the whims of petrostate dictators such as the Russian president, Vladimir Putin, and Saudi Arabia’s own leader, Crown Prince Mohammed bin Salman (widely known as MBS). We should be thankful that both men failed in their apparent attempt to influence the US 2022 midterm election by sharply cutting oil production in early October.  

Yet another reason for optimism has to do with markups – the amount by which prices exceed costs. While markups have risen slowly with the increased monopolisation of the US economy, they have soared since the onset of the Covid-19 crisis. As the economy emerges more fully from the pandemic (and, one hopes, from the war) they should decrease, thereby moderating inflation. Yes, wages have been temporarily rising faster than in the pre-pandemic period but that is a good thing. There has been a huge secular increase in inequality, which the recent decrease in workers’ real (inflation-adjusted) wages has only made worse.

The Roosevelt report also dispenses with the argument that today’s inflation is down to excessive pandemic spending, and that bringing it back down requires a long period of high unemployment. Demand-driven inflation occurs when aggregate demand exceeds potential aggregate supply. But that, for the most part, has not been happening. Instead, the pandemic gave rise to numerous sectoral supply constraints and demand shifts that – with adjustment asymmetries – became the primary drivers of price growth.

Consider, for example, that there are fewer Americans today than there were expected to be before the pandemic. Not only did Trump-era Covid-19 policies contribute to the loss of more than a million people in the US (and that is just the official figure) but immigration also declined, owing to new restrictions and a generally less welcoming, more xenophobic environment. The driver of the increase in rents was thus not a large increase in the need for housing but rather the widespread shift to remote work, which changed where people (particularly knowledge workers) wanted to live. As many professionals moved, rents and housing costs increased in some areas and fell in others. But rents where demand increased rose more than those where demand fell decreased; thus, the demand shift contributed to overall inflation. 

Let us return to the big policy question at hand. Will higher interest rates increase the supply of chips for cars, or the supply of oil (somehow persuading MBS to supply more)? Will they lower the price of food, other than by reducing global incomes so much that people pare their diets? Of course not. On the contrary, higher interest rates make it even more difficult to mobilise investments that could alleviate supply shortages. And as the Roosevelt report and my earlier Brookings Institution report with Anton Korinek show, there are many other ways that higher interest rates may exacerbate inflationary pressures.

Well-directed fiscal policies and other, more finely tuned measures have a better chance of taming today’s inflation than do blunt, potentially counterproductive monetary policies. The appropriate response to high food prices, for example, is to reverse a decades-old agricultural price-support policy that pays farmers not to produce, when they should be encouraged to produce more.

Likewise, the appropriate response to increased prices resulting from undue market power is better antitrust enforcement, and the way to respond to poor households’ higher rents is to encourage investment in new housing, whereas higher interest rates do the opposite. If there was a labour shortage (the standard sign of which is increased real wages – the opposite of what we are currently seeing), the response should involve increased provision of childcare, pro-immigration policies, and measures to boost wages and improve working conditions.

After more than a decade of ultra-low interest rates, it makes sense to “normalise” them. But raising interest rates beyond that, in a quixotic attempt to tame inflation rapidly, will not only be painful now; it will leave long-lasting scars, especially on those who are least able to bear the brunt of these ill-conceived policies. By contrast, most of the fiscal and other responses described here would yield long-term social benefits, even if inflation turned out to be more muted than anticipated.

The psychologist Abraham Maslow famously said: “To a man with a hammer, everything looks like a nail.” Just because the US Federal Reserve has a hammer, it shouldn’t go around smashing the economy.

Even super-tight monetary policy is not bringing down inflation

 

Welcome to Hikelandia, writes The Economist, where price growth just won’t cool

Oct 23rd 2022 | SANTIAGO

It feels a little unfair. In July 2021, as rate-setters in America and Europe dismissed the risk of entrenched inflation, the Central Bank of Chile got its act together. Worried that inflation would rise and stay high, its policymakers voted unanimously to lift rates from 0.5% to 0.75%. The bank has since raised again and again, outpacing investors’ expectations and taking the policy rate all the way up to 11.25%. Perhaps no other central bank has pursued price stability with such dedication.

Has the star pupil been rewarded? Hardly. In September Chile’s prices rose by 14% year on year. The central bank’s preferred measure of core inflation accelerated to 11% year on year.

Chile’s example speaks to a wider problem. Many pundits say that if only the Federal Reserve, the European Central Bank and others had “got ahead of the curve” by quickly raising rates last year, the world would not be struggling with high inflation today. The experience of Chile, and other places that tightened early and aggressively, casts doubt on that argument. All over the world, it is proving extraordinarily difficult to crush prices.

The Economist has gathered data on Chile and seven other countries in which the central bank started a tightening cycle at least a year ago, and did so after having slashed interest rates to an all-time low early in the covid-19 pandemic. The group includes Brazil, Hungary, New Zealand, Norway, South Korea, Peru and Poland. Although Russia would have qualified, we have excluded it because its circumstances are unique.

Call the unlikely gang “Hikelandia”. In the year to October 2022 the median economy in Hikelandia raised rates by about six percentage points. If as expected the Federal Reserve raises rates by 0.75 percentage points on November 2nd, America’s cumulative increase over the past year will still be nowhere near as big.

Unsurprisingly, turning the monetary screws has slowed Hikelandia’s economy. The housing sector has quickly come off the boil as mortgage rates have risen. House prices are drifting down in New Zealand. South Korea’s pandemic housing boom has ended. Goldman Sachs, a bank, produces a “current-activity indicator”, a real-time measure of economic strength. Using its data, we find that Hikelandia’s economy is weakening relative to the global average. And there is worse to come. Chile’s central bank expects gdp to shrink next year.

Inflation, however, remains stubborn. Central banks often focus on the rate of “core” inflation, which excludes volatile components such as energy and food, and better reflects domestic inflationary pressures. In September core inflation in Hikelandia’s economy hit 9.5%, year on year, up 3.5 percentage points from March. Worse still, the gap between global core inflation and Hikelandia’s reading seems to be widening, not shrinking.

Dig into the national statistics of Hikelandia, and the trends become even more concerning. Chile’s wage growth continues to accelerate. In September South Korea’s inflation rate in the labour-intensive service sector was 4.2% year on year, its highest since the early 2000s. In the past six months Hungary’s service-sector inflation has climbed from 7.2% to 11.5%. Across the club, inflation is becoming more “dispersed”, affecting a wider range of goods and services. In September the price of 89% of the components of Norway’s inflation basket rose by more than 2% year on year, up from 53% six months before. In research on Poland, published in late September, economists at Goldman Sachs found evidence that “underlying inflation momentum has picked up again”.

Hikelandia’s struggles raise three possibilities. The first is that it is currently unrealistic to expect inflation to fall. Research suggests that there are lags, sometimes long ones, between tighter monetary policy and lower inflation. It is also tricky to control inflation when almost every currency is depreciating against the dollar, making imports more expensive. All this may be true. But after being surprised again and again by inflation, you would be brave to bet that Hikelandia’s inflation will soon be anywhere near central banks’ targets, even if conditions begin to improve.

The second possibility is that policymakers, including those in Hikelandia, have not been sufficiently courageous. Perhaps central banks should have raised interest rates more aggressively. This is an argument stridently made by Chile’s remaining “Chicago Boys”, libertarian economists who spearheaded the country’s free-market reforms in the 1970s.

Governments might also do more to help out. After ramping up spending when the pandemic struck, the median budget deficit in Hikelandia has fallen, but is still wide at 3% of gdp. Further increases to taxes or cuts to public spending would help reduce demand. Yet this strategy carries risks, too. Implementing austerity during a cost-of-living crisis would be deeply unpopular. And Chile, which has nonetheless taken the plunge and is forecast to run a budget surplus this year, is still seeing little payoff in terms of lower inflation.

That leads to a third possibility—and the most worrying one. Perhaps inflation is simply harder to stop than anyone could have predicted a year ago. In a report published in the summer the Bank for International Settlements, a club for central banks, hinted at this possibility. In a “low-inflation regime”, the norm before the pandemic, no one paid much attention to prices, ensuring they did not rise quickly. But in a “high-inflation regime”, such as in the 1970s, households and firms start to track inflation closely, leading in time to “behavioural changes that could entrench it”. If the world has shifted from one norm to another, then more creative tools will be needed to cool prices. 

A political backlash against monetary policy is looming

Martin Sandbu in The FT

Three weeks ago, Sanna Marin, Finland’s prime minister, retweeted a link to an article by a Finnish academic together with the following quote: “There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession.” 

Defenders of those prevailing ideas predictably pushed back, warning against second-guessing independent central banks or not valuing their credibility. But defensiveness is the wrong response. Not just because Marin didn’t actually criticise any central bank actions. But, more profoundly, because avoiding a debate over whether our macroeconomic regime is fit for purpose is more perilous than having one. 

Comparisons with the 1970s often fail to notice one important lesson of that decade: a macroeconomic regime that cannot justify itself will be toppled, first intellectually, then politically. It was from the ashes of 1970s monetary chaos that theories were born justifying independent central banks with a mandate to keep inflation low. Before the century was out, independent inflation-targeting was de rigueur in most advanced economies. 

Forty years on, a new intellectual and political reckoning would be less surprising than the absence of one. The “great moderation” produced by the 1980s monetary revolution has in many countries long been accompanied by stagnant wages for the low paid. The glacial recovery from the global financial crisis prompted the world’s two biggest central banks to revise their policy framework during the pandemic. In 2020 and 2021, the Federal Reserve and the European Central Bank vowed to tolerate a period of higher inflation if employment had further to rise or there would be little room to loosen policy in case of a downturn. But this new attitude fell at the first hurdle. 

With cost of living crises biting and recessions looming in key advanced economies, what are the odds of avoiding a more profound reckoning for much longer? Marin is not the only national leader expressing unease about central banks. French president Emmanuel Macron recently worried aloud about “experts and European monetary policymakers telling us we must crush European demand to contain inflation better”. 

Precisely because central bankers are independent, it falls to political leaders to tell their citizens why it is right to meet Russian energy blackmail with actions to clamp down further on incomes and jobs. They would be remiss if they did not question whether this is the best we can do. 

In comparison, central bankers have it easy. They have legally imposed inflation-fighting mandates, which are not for them to question. And they have an argument: that losing their “credibility” — by which they mean people no longer believe they can keep inflation low — will cost even more jobs and lost income. 

But the credibility of central banks itself is only as good as the credibility of the macroeconomic regime as a whole. That is not to say central bank independence should be jettisoned, but to ask openly whether it actually works for the economy. 

In pursuit of individual mandates central banks may be collectively overtightening, as Maurice Obstfeld has suggested. Or monetary policy uncoordinated with fiscal policy may be making matters worse, as Marin hinted in follow-up comments. 

The IMF has warned governments against budgeting “at cross-purposes” with monetary tightening. But raising interest rates puts monetary policy at cross-purposes with fiscal policy priorities such as investing in the green transition or, indeed, in energy infrastructure that would itself remedy energy-induced inflation. Even if monetary considerations should take priority, such monetary dominance is undoubtedly something to be democratically debated, not technocratically imposed. 

It may even be that central bankers are not independent enough but cave in to the political pressure arising from each new monthly record in current inflation, rather than coolly focusing on their benign medium-term forecasts. 

Like in the 1980s, in time bright economists will suggest better ways of designing monetary policy against energy price shocks. And unless we have a lucky escape from a sharp downturn this winter, a political backlash is surely coming too. The alternative to openly debating these issues in a democratic space is to let that backlash fester until it breaks out in the more radical and dangerous form of a populist assault on institutions. Central banks’ credibility would not be worth much then.