By Alex Hughes | News Editor
As the world recovers from the COVID-19 pandemic, it finds itself perilously close to an inflation crisis. In October, the UK’s yearly inflation rate climbed to 4.2%, the highest in a decade. Equivalent measures hit 4.1% in Europe, and 6.2% in the United States, the highest rate since the 1990s. In the UK, core inflation, which excludes more volatile goods – food, alcohol and energy, whose price fluctuations are often very short-lived – rose by 3.4%.
Far more concerning for policymakers are trends in inflation expectations. These can be gathered from consumer or firm surveys, but respondents aren’t exposed to losses if their predictions are wrong, so economists tend to infer the expectations of traders. This is done by looking at the difference between the interest rates on government bonds adjusted for inflation, and those that aren’t.
In the UK by late October this measure implied an average annual inflation rate over the next ten years of 4.25%, more than double the Bank of England’s (BoE) 2% target. A failure of that magnitude could permanently compromise its credibility.
Last month, the BoE chose not to raise rates. While it might appear not to have done anything in the last year, interest rate policy is in fact loosening by the day, because with every uptick in inflation expectations, the inflation-adjusted interest rate – which is what matters for consumption and investment decisions – falls. Although it’s widely expected to raise rates at its December meeting, it might already be far behind the curve.
According to many central bank spokespeople, the driving force behind the rise in prices lies in global supply chains. Demand is rising as lockdown measures ease and consumers start spending more, and when supply can’t expand, increases in demand raise prices rather than output. Currently, supply chains around the world are beset by delays and bottlenecks.
And indeed, a lot of the recent media commentary focuses on specific supply problems in individual markets. The Biden administration, for its part, is pointing the finger at individual companies or groups of companies for rising prices, calling on the Federal Trade Commission to investigate collusive behaviour in oil and gas markets.
Energy market analysts have cast doubt on the evidence the White House presented, but the deeper issue here concerns the nature of inflation. Reports of turmoil in individual supply chains, though they certainly make for interesting stories, can lead people to think that inflation arises from a thousand cuts – that a rise in the price of a product ‘drags the average up’, as it were. In fact, the link here is fairly weak.
Inflation is a general rise in the price of goods that consumers spend their money on. When the price of something goes up, consumers don’t just grit their teeth and keep buying goods and services in the same proportions. Constrained by their income, if they’re determined to keep purchasing it in the same quantity they’ll have to spend less on other goods, whose prices will then fall. More often, they will buy less of the product, reducing its importance in the inflation index.
The fact that prices don’t respond instantaneously to changes in demand complicates this picture. Different speeds of adjustment can mean that changes in individual prices temporarily affect the average, but this isn’t the main story. The main story is central bank policy.
As part of their decision-making process, central bankers use models. Typically, these models tie the behaviour of inflation to three variables: expected inflation in the next period (often the next quarter), the extent that productive resources like labour and machinery are being used, and temporary increases in the cost of production.
If firms think inflation is set to rise, then they’ll pre-emptively raise the prices of their products to prevent their real prices from falling. Likewise, consumers will bring forward consumption, before their money loses value in the next period. So, to a large extent, inflation expectations are self-fulfilling.
If spending in the economy exceeds a certain threshold, then inflation will increase ‘mechanically’ – if few extra resources are available to use in the production process, then the cost to produce each additional good rises, since more workers are required and they must all use a given stock of productive assets, like machinery, that are already in use.
And, if the price of a key input like energy rises, then production costs increase for all the products whose creation involves that input.
So, theory implies that inflation positively responds to rising GDP – the total amount of goods and services produced in an economy. But to find the magnitude of that response, researchers must confront data. In an influential paper released last year, Berkeley’s Emi Nakamura and co-authors argued that in general, the response is weak, and that expectations tend to play the central role.
Some clear implications can be drawn. First, the rapid growth in UK GDP as the lockdown measures eased was always going to be accompanied by an increase in inflation. But second, if policymakers allow inflation expectations to rise much further above target – implying the central bank’s credibility is eroding – then reducing inflation mechanically might prove to be very difficult, with central banks having to engineer outright recessions.
Expectations are a thorny issue in these models, because their self-fulfilling nature – and the fact that people can expect anything – leads to an infinite number of possible outcomes. To collapse this array of possibilities down to a single one, the central bank has to commit to raise interest rates in response to a rise in inflation more than one-for-one, to ensure that the inflation-adjusted interest rate increases, so that overall spending falls.
Of course, the Bank of England has not followed this principle in the last year, allowing inflation to surge far above target without raising interest rates. None of the other major central banks have followed it either. Two reasons for their hesitancy stand out.
Policymakers, as Churchill said of generals, stand ready to fight the last war. During the recession just over a decade ago, many governments made reductions in borrowing a key priority. It’s now widely agreed that in some of these countries, including the UK, the tax rises and spending cuts that the strategy entailed exacerbated the fall in overall spending that led to the fall in GDP. With their interest rates already lowered to zero, central banks were not in a position to offset this, and GDP remained far below its long-run trajectory for much of the last decade.
In the last year, determined to avoid repeating these errors, governments and central banks held firm. Rather than pre-emptively tightening policy, they would wait until they could ‘see the whites of inflation’s eyes’. In practice, it came faster than they had expected and, it turned out, faster than they were prepared to effectively respond to.
In addition, most central banks aren’t solely focused on inflation – explicitly or not, they also have GDP and unemployment objectives. Their models point to trade-offs between inflation and growth, and in the last decade, the Bank of England has implicitly shifted its emphasis toward the latter, allowing more room for inflation to overshoot the target. But while the case for augmenting inflation targets is an easily defensible one, it should go without saying that central banks neither expected nor wanted the overshoot to go this far.
With inflation now surging, it’s no surprise that central banks are facing growing calls to explain their behaviour. To ask whether they are responsible for the surge in inflation is like asking whether someone gained weight because they started eating more, or because they failed to offset those extra calories with more exercise. If they’d set themselves the goal of nimbly adjusting their exercise regimen in line with fluctuations in their diet in order to keep their weight stable, and then their weight rose, the failure was the lack of exercise.
‘‘It is dangerous when central banks stop saying that if inflation is high, it’s because of what they’ve done or not done”, Ricardo Reis, a professor at the London School of Economics, noted in a recent presentation, “Because inflation is a monetary phenomenon. There are headwinds and tailwinds, but control of the monetary base and interest rates gives overwhelming power to the central bank”.
Conceptually, inflation is best thought of not as the rise in the price of products, but its flipside – the fall in the real value of a currency. In that light, it’s easy to see why the buck stops with the issuer of that currency. And to be sure, the Bank of England still has the opportunity to course-correct in the next few months. There will be trade-offs, but the more that inflation is allowed to embed itself, the starker those trade-offs will become.