Questions in the wake of the global inflation hit

Hello. While we are waiting for election results in the UK and France — do use your vote if you are a citizen of either country — spare a thought for monetary policy. Inflation is more or less back in its box, and central banks are preparing to cut interest rates or have already started. It’s a good time to lift our eyes from the immediate question of what to do about price rises to what we can learn from the inflation hits we are now putting behind us.

The inflation of the past couple of years had two important features. It took almost everyone by surprise, including central banks. And there was, and still is, no agreement on how we should understand it — in particular, how much of it was driven by excessive aggregate demand, rather than supply shocks or the shift in the composition (not the total quantity) of US consumer demand from services to goods.

All this makes it worthwhile to stand back and try to understand better what has happened. So it’s welcome that the “lessons learnt” observations are beginning to come on stream. In just the past month or so, I have tallied a short paper from the Bruegel think-tank and a longer report for the European parliament, which focus squarely on the European Central Bank, as well as a much more general chapter in the Bank for International Settlements’ annual economic report.

Chris Giles has written a great piece on the BIS report. I agree with him that the institution is making it far too easy for itself when it celebrates central banks for coming good (if a little late) in vanquishing inflation. While Giles is much closer to the BIS view than me, he points out that the evidence the BIS presents does nothing to refute those of us who think inflation came and went away for reasons that had little to do with monetary policy. I pointed out last year how the recent inflation featured a lot of “observational equivalence”, or data consistent with several very different interpretations. The argument largely comes down to whether you think it’s because of central bankers’ determination that public inflation expectations remained quiescent throughout — what I have called the Jedi central bankers theory of inflation — rather than, say, that the public understood the energy price acceleration to be a one-off.

So in this newsletter I will not address the debate on whether central bankers were lucky or competent in reducing inflation, which Giles has covered so well. To my mind there are two other related questions about the recent monetary past that matter a great deal for future policy, and on which people disagree quite significantly.

One concerns whether central banks’ loose monetary policy in the years before Covid-19 was more or less the right stance. On this question, the BIS does as the BIS is wont to do, and warns politely but sternly against “testing the limits of sustainable economic expansions . . . In the case of inflation, the temptation to boost economic activity in the short term can call for a larger contraction down the road, as monetary policy needs to squeeze inflation out of the system. In the case of financial imbalances, their spontaneous unwinding would itself cause a costly recession and possibly financial crises.” It is easy to read this as a criticism of the recent policy reviews of the Federal Reserve and the European Central Bank, which accepted a certain tolerance for overshooting inflation targets temporarily for the sake of higher employment and economic activity.

But in a recent FT op-ed, Julia Coronado reviews the evidence for “running the economy hot” — ie keeping demand growth strong through both monetary and fiscal policy — and finds it supportive. In her reading, the US’s uniquely high-pressure economy (with large fiscal stimulus offsetting monetary tightening once that came) is the reason for the astonishing American outperformance since the pandemic; including on labour productivity as her chart below shows.

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A second question is whether our current monetary (and wider economic) policy toolbox is fit for purpose. If you take the BIS view that central banks did a good job and it was they that won the battle against price rises, you are likely to lean towards the view that the framework is fundamentally sound and all that is needed is to do an (even) better job within it. But what if the shocks were ones central banks are ill-equipped to handle, and that such shocks may well come fast and furious in the times ahead?

That is the warning put forward both by Bruegel’s Lucrezia Reichlin and Jeromin Zettelmeyer and by Jens van ’t Klooster and Isabella Weber in their report to the European parliament. More soberly than the BIS, Reichlin and Zettelmeyer write that:

It is too early to evaluate whether [raising rates against an energy price shock] was the right strategy, and in any case a counterfactual scenario with less-aggressive monetary policy is hard to establish. What is clear, however, is that the environment in which supply and demand shocks happened in 2021-22, and in which they might happen in the future, might depart from the textbook model in multiple ways. To avoid major policy mistakes in the future, the ECB’s strategy might need to be adjusted in several ways.

Reichlin and Zettelmeyer aim to raise questions rather than give more than just tentative hints at answers, such as suggesting a need to be more patient in stabilising overall inflation to give the economic system time to adjust relative prices between sectors. This is clearly the right thing to think about — the excellent Geneva report, which Reichlin co-authored, highlighted just how complex inflation dynamics are in the presence of shocks against individual industrial sectors.

Van ’t Klooster and Weber make more ambitious policy proposals. Since monetary policy alone is not well suited for the kind of shocks we have experienced (big price shocks in systemic sectors such as energy and food), they argue, there is an “inflation governance gap” to be filled. They propose fiscal and structural policies of keeping buffer stocks of key industrial inputs and temporary price controls — which, on the whole, were rather successfully implemented by several European countries but in a very ad hoc manner. (Governments intervened in gas reservoir filling, purchases, use restrictions and energy pricing in a much more hands-on way than usual.) The authors sensibly call for more co-ordination both between countries inside the EU and between different policy institutions such as the ECB and other EU bodies.

There is much to like here, although a much more comprehensive policy discussion would be needed than they provide to be sure of what would be a good idea and what merely sounds like one. In particular, I would not want to lose sight of policies that aim to allow marginal prices to be set by markets so as to retain incentives to economise on newly scarce goods, while compensating or controlling prices for reasonable minimum quantities of, say, energy use per household.

Free Lunch readers know that on both these two big questions, I tend to the non-conventional side — in favour of high-pressure macroeconomic policy and seeing little contribution of monetary policy against the recent “shockflation”, as van ’t Klooster and Weber nicely dub it. But the bigger point is that whatever your view, you should recognise that these are two big and consequential questions that need to be thought hard about and answered well. A lot of economic policy judgments are going to depend on it.

Finally, a bonus question: what about climate change? Both the Bruegel and the European parliament reports highlight that one paradox of raising rates against shockflation is that it makes it more expensive to invest in the infrastructure that would diminish the impact of such shocks in future. There are now plenty of examples of big developers reining in their plans for renewables — and one big reason is higher interest costs. The “relative returns simply aren’t there”, one observer points out. And in a separate paper, Weber and three co-authors find that “carbonflation” — the rise in carbon prices as climate change policies develop — is concentrated in a few sectors, showing how climate change and sectoral shockflation are closely related. So does the impact on climate change on the level and swings in food prices, a big headache for central banks.

Monetary policy has the tools to create a “green spread” or a “green premium”, so that investments apt to mitigate the risk of climate-related shockflation face easier financial conditions than other investment projects. Already the Bank of England, the ECB and the Bank of Japan have implemented programmes aiming to incentivise particular segments of credit growth. Being as we are at the start of a loosening cycle, this is a good time to expand such programmes directed at green investments. This could lower rates on them exclusively, or faster than other rates, at a pace calibrated to get average financial conditions where they need to be for macroeconomic reasons, but where green investments benefit from a much faster loosening. Bring the green spread in!

Other readables

With France bracing for the far right’s best electoral results ever, the country may want to look to Nordic experiences. As I wrote in my FT column this week, the knee-jerk cordon sanitaire may no longer be fit for purpose.

Hungary’s Prime Minister Viktor Orbán writes in the FT about how to make Europe great, sorry, competitive again (and not a whisper about withheld European funds).

A new study looks at the cost of Brexit at a regional and local level. England, Scotland and Wales are 8 to 10 per cent off in terms of local economic output than it is estimated they would have been had Brexit not happened. Northern Ireland, however, is no worse off than in the counterfactual. The Northern Ireland protocol, which maintains Northern Ireland’s access to the EU single market for goods, has clearly done the region some good!

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