The squeeze is on

The politics …

It is hard to recall a time when a government has been so out of touch with the electorate as that led by Boris Johnson. As the squeeze on incomes posed by inflation rises up the agenda and the government doubles down on Brexit, there is a sense that a lot of things are becoming unglued. In a series of events guaranteed to cause apoplexy amongst party communications managers, Conservative MP Lee Anderson suggested that people needed to learn how to cook and budget "properly", rather than use food banks whilst his colleague Rachel Maclean recommended that people could improve their circumstances by working “more hours or moving to a better-paid job.”

Up until six months ago, despite the warnings signs of incompetence, the Conservatives were still ahead in the polls. The Owen Paterson affair provided the first sign that the electorate was fed up with being taken for fools – a trend which was reinforced by the Partygate scandal. Despite the flow of bad news, however, the Tories are not as far behind in the polls as might be expected. Indeed, Labour’s lead has remained steady at around six percentage points and were this to remain unchanged, it would unlikely be able to form an outright majority following the next election. For the record, Electoral Calculus currently predicts that Labour will win 315 seats – six short of an outright majority (for what it is worth, my own assessment is that Labour might struggle to top 300 seats).

… and the economics

Despite all the political noise surrounding Partygate which has sent the commentariat into overdrive, it is good old-fashioned economics which poses the biggest current threat to the Conservatives’ electoral chances. The cost of living squeeze, triggered by a 40-year high inflation rate in April (CPI at 9% or 11.1% using the RPI measure), is the biggest current problem. In fairness, this is largely the result of exogenous factors beyond the government’s control, particularly with regard to energy prices. However the government does have control over its response, and as the comments from the two MPs above illustrate, this has been sadly lacking.

The main criticism is that it has done little to nothing to protect low income households from the full impact of the squeeze. An uplift of 54% in the energy price cap last month is a regressive move that will hit poorest households the hardest, whilst low income families also have to contend with a food inflation rate running at 6.6%. The March Budget represented a wasted opportunity to provide some support whilst at the end of April, Chancellor Rishi Sunak suggested it would be “silly” to provide support on energy bills before knowing what is likely to happen to prices in the autumn (this from someone who, along with his wife, has just been named as the 222^nd wealthiest person in the country). In fairness, the government has granted a £150 Council Tax rebate this year but according to the OBR much of this will be clawed back over the next five years via a new tax on energy bills, which on a Ricardian equivalence basis does not represent much help at all.

In addition to blaming the public for their inability to cope with the inflation crisis, senior Conservative politicians have tried to pin the blame for the inflation spike on the Bank of England. It was accused by the Chairman of the Treasury Committee of being “asleep at the wheel” whilst the Tory peer Michael Forsyth accused it of “unleashing inflation in our country through failing to meet its proper mandate.” I will deal with the BoE’s position in a future post, but suffice to say that although it has made mistakes, this represents a blatant attempt by the government to deflect blame for its own failures.

Aside from the welcome support provided during the early stages of the pandemic, fiscal policy has generally been too tight over the past decade. George Osborne’s misguided austerity policy meant that the BoE was required to do much of the heavy lifting on policy in the wake of the GFC and the failure to provide sufficient fiscal support in recent months is one reason why the central bank has not been more aggressive in raising interest rates. There is general agreement that fiscal rather than monetary policy is the appropriate tool to provide targeted help to those most in need, and it is incumbent on the government to act rather than apportion blame. It is not as though there is a lack of options.

What can they do?

In the first instance, the government could reintroduce the uplift to Universal Credit payments used during the pandemic with NIESR calling for a rise of £25 per week which it estimates would cost £2.7bn this fiscal year. The Chancellor would doubtless argue that this will simply raise the fiscal deficit. However, it would do so by less than he thinks given that higher-than-expected inflation will boost revenues via fiscal drag following last year’s decision to freeze tax thresholds. An additional measure would be to temporarily reduce VAT on domestic fuel bills to zero and sell it as a Brexit win (EU rules do not permit this to fall below 5%). Removing the levy to fund renewables investment and energy efficiency improvements from household bills, as energy suppliers have called for, would shave another 7.8% from outlays. Adding in the Council Tax rebate, these measures would limit the latest rise in household energy bills to 23% rather than the 54% mandated by the energy price cap.

Labour has called for the imposition of a windfall tax on the profits of energy companies – a measure which the government has so far resisted. There is some merit behind the idea of such a tax. Shareholders who happen to be holding stock at the right time have simply benefited from an exogenous factor beyond their control whilst energy consumers bear the cost. With energy companies making big profits and BP’s profit having doubled in the first quarter of the year, it may be an idea whose time has come (again). Such windfall taxes have been tried before: In 1997, the Labour government imposed an additional levy on the profits of recently privatised industries, arguing that they had been sold off too cheaply. In 1981, Margaret Thatcher’s government taxed the additional profits made by banks as a result of rising loan spreads which were a result of rising short-term rates.

However, there are also many good arguments against the idea. The basis of a good tax system is that it should be fair, certain, convenient and efficient but a windfall tax would violate some of these principles. Most voters would agree that a windfall tax is fair; it is also convenient in that it would be easy to collect. However, it would introduce uncertainty about the future tax regime which would undermine the basis of the system. It would also be fiscally inefficient since it could hamper investment in cleaner energy where energy companies are in the vanguard. Finally, since a windfall tax is designed to tax supernormal profits, how do we determine what is a normal level? There is also the problem that the revenue derived from taxing energy companies would come too late to provide relief for households that are struggling right now. My own conclusion is that whilst there is a discussion to be had about levying higher taxes on energy companies, it might be more efficient to do so via the usual channels by which changes are advised well in advance. In the meantime, some of the other measures outlined above might be more appropriate.

Act now or risk an electoral drubbing

There is no doubt, however, that households are struggling to make ends meet. Consumer sentiment has fallen to its lowest level since the data were first reported in 1974 (chart above) and forecasts from both NIESR and the BoE reckon that the UK will come very close to recession by end-year (even if a technical recession is avoided). Whilst acknowledging that many of these factors are beyond the government’s control, it does control its response. Since the government sold Brexit as an idea that would make people better off whereas the opposite has occurred, there is increasingly a sense that it has a duty to step in (Brexit will undoubtedly be the subject of another post). Failure to deliver on this most basic of Brexit promises is likely to mean the electorate will not be in a forgiving mood the next time the government asks for their vote.

Getting a grip on inflation

There is an old joke about a man who gets lost in the countryside and asks a local for directions to the nearest town. The local responds: “if it’s the town you’re going to, I wouldn’t start from here.” In many ways that perfectly sums up the position central bankers find themselves in today. Inflation has ramped up in a way that was unforeseen just six months ago and as a consequence interest rates are currently too low for prevailing inflation conditions. It is a very uncomfortable place to be because it opens up central banks to the charge that they are behind the curve on policy.

Onwards and upwards

It is very easy to make the case that central banks missed the inflation surge and have maintained a lax monetary stance for too long. On a literal interpretation this is true. There again, the consensus forecasts did not anticipate the inflation surge either so the noisy brigade perhaps ought to dial down some of the criticism about how slow central banks have been to react. We can see this very clearly in UK data using consensus forecasts for CPI inflation in Q4 2021 against the BoE’s projections (chart below). If anything, the central bank anticipated the inflation surge slightly quicker than most forecasters.

Perhaps the criticism is rooted in the fact that central banks were tardy in tightening policy as the economy normalised following the GFC of 2008-09. I have a lot more sympathy with this view. There was no justification for maintaining the lax stance adopted in 2009 once the economy started to normalise and those criticising central banks today perhaps feared a repeat of the policy mistakes of the 2010s which promoted significant inflation in financial asset prices.

At least the BoE has begun the process of raising interest rates, having increased them by a total of 40 bps over the last two months with more to come. Last month the Fed passed up the opportunity to raise rates and instead signalled a March rate hike whilst continuing its asset purchase programme for another six weeks rather than bringing it to an immediate end. As for the ECB, the depo rate has not been above zero since 2012 and has been stuck in negative territory since 2014. Negative rates may be an acceptable policy option for a limited period but eight years is way too long. At least this week’s press conference provided some indication that the ECB acknowledges “inflation is likely to remain elevated for longer than previously expected [and] risks to the inflation outlook are tilted to the upside, particularly in the near term. The situation has indeed changed." Suggestions from some analysts that this marked a “hawkish” stance from the ECB is rather to miss the point. Moving rates from negative territory to zero is not “hawkish” – it reflects the start of a long-overdue normalisation of the policy stance.

Given the nature of the supply-generated inflation shock it is clear that a rise in interest rates is not going to resolve the problem. But in one sense central banks have no choice but to react. By claiming credit for the fall in inflation during the 1990s they have created a paradigm in which they appear to have control over the inflation process. Under current institutional arrangements, in which central banks maintain responsibility for controlling inflation, their whole credibility is bound up in taking action to curb it which in turn requires tightening policy. However, there may be something of the emperor’s new clothes about this argument. A hugely simplified view of using monetary policy to control inflation is the assumption that it is (to use Milton Friedman’s phrase) “always and everywhere a monetary phenomenon.” As recent events have shown, that is not the case. How do we act then upon inflation?

Dealing with the energy shock

One of the problems facing consumers around the globe is the sharp rise in energy prices. European gas production has declined in recent years and to the extent that this was used largely to smooth out demand patterns during the winter, this has had a significant impact on the market. Last summer European countries were also unable to boost storage to levels that might prevent shortages from emerging during the coldest periods and the resultant scramble for gas has pushed up global prices.

This is making its presence felt in household fuel bills. UK domestic gas and electricity prices rose by 19% and 17% respectively in October and will rise again in April following the Ofgem announcement that the energy price cap will rise by 54% which is likely to push inflation to 7% or above in Q2. Whilst the problem of rising energy costs is not a uniquely British phenomenon, it has taken a different approach to other European countries. In the UK Chancellor Rishi Sunak announced that households would receive a discount of £200 on domestic energy costs in 2022 (around 10% of an average bill) which would be repaid over the following five years. The full impact of the price hike will therefore be borne by consumers.

Elsewhere in Europe, governments have taken a more aggressive approach. With one eye on the election, the French government has forced state-owned EDF to sell nuclear power to rivals at below the current market price, costing it €8.4bn in revenue, whilst limiting the rise in household bills to 4%. The German government plans to reduce the green energy surcharge by 46% and introduce subsidies for lower income households (one person households would receive €135 and a two person household would receive €175) whilst the Irish government has planned a €113 energy rebate to every household.

Calls for wage restraint are missing the point

BoE Governor Andrew Bailey came under fire for suggesting that this week’s 25 bps rate hike was implicitly designed to deter workers from demanding big pay rises. But as many people pointed out, nothing screams wage restraint like a big rise in basic living costs. In any event workers real wages have lagged productivity growth in the decade since the GFC (chart below). Even though there has been a narrowing of the gap since 2018, workers have not been compensated for such productivity growth as has been achieved since 2009. That said, the ratio is currently in line with its long-term average. But this implies that even in a zero productivity growth economy, workers are entitled to flat real wage growth and with inflation set to average close to 6% this year, a nominal wage rise of 6% could be justified on economic grounds.

The governor’s comments were (to be polite) somewhat insensitive. It would have been far better to suggest that the BoE is raising rates to keep down inflation in order that the pay packet can stretch a little further. The FT journalist Martin Sandbu also posed the question “why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins?” With BP set to announce a huge rise in profits at a time when energy customers are struggling to find the means to pay their bills, calls for wage restraint are not a good look.

None of this is to say that central banks should not raise interest rates further. But we have to recognise that this will do little to tackle the underlying problems and that a tightening of the monetary stance maybe should be accompanied by fiscal measures to offset some of the pain, especially since rapid inflation will also boost the government’s fiscal revenues. At a time when the government is struggling to remain credible, and when many prominent Brexiteers promised that prices would go down once the UK left the EU, they need to get a grip on the inflation problem soon or voters may be tempted to take their revenge at the ballot box.

The cost of living problem

The biggest economic surprise of 2021 was the resurgence of inflation. This was largely unforeseen at the start of last year and even by the spring was still not expected to become a significant problem. Thus the news that global inflation has hit multi-decade highs is an unwelcome development for households who have to deal with the fact that prices are increasing much more rapidly than wages and central banks who have to decide how to respond.

People aged 30 or younger were not even born the last time European inflation rates reached current levels. Data for December showed the German inflation rate at 5.3% – the highest since 1992, which was also the same year CPI inflation in the UK last exceeded the December reading of 5.4%. We have to cast our minds back to the era of Paul Volcker for the last time the US inflation rate exceeded the 7% rate posted in December (1982, for the record). Those who thought high inflation was a thing of the past have had an uncomfortable awakening in recent months. This is attributable to a combination of global supply bottlenecks in the wake of the pandemic and rising energy prices, both of which are likely to prove temporary (although temporary could mean anything up to two years). Both these elements were encapsulated in the UK data for the transport component of the CPI, which accounted for almost one-third of the annual inflation rate last month. The cost of vehicle purchases rose by 13.9% in the year to December with shortages of key components pushing up prices, whilst fuel costs were up 26.6% on the back of higher oil prices.

UK inflation is set to go higher still when the domestic energy price cap is raised in April. This sets a limit on the maximum amount suppliers can charge customers for each unit of energy consumed. The new cap will be announced in February but is expected to rise by anything between 46% and 56% on the basis of recent trends in wholesale energy prices. Other things being equal this may be enough to push CPI inflation close to 7% in Q2 (chart below). For the record, the BoE’s November forecast pointed to an inflation rate of 4.8% in the second quarter: we can expect a significant upward revision when the new forecast is released next week.

A cost of living “crisis”

All this has given rise to lurid headlines about a “cost of living crisis” and the possibility that many UK households will be pushed into fuel poverty, officially defined as above average fuel costs that push their residual income below the poverty line (a rough rule of thumb adopted in Scotland, Wales and Northern Ireland is that a household suffers from fuel poverty when it spends more than 10 per cent of its income on fuel). The poverty campaigner Jack Monroe made the point in a Tweet that subsequently went viral that the index used in calculating the cost of living “grossly underestimates the real cost of inflation” using the case of rising food prices as an example.

This is both right and wrong. It is right because the CPI is calculated on the basis of average spending shares on particular categories of goods and services, but these differ according to income. Thus if prices rise more quickly for those categories where poorer households have a high spending weight, the average CPI inflation rate will understate their “true” inflation rate. But that was not the case in 2021. I am indebted to the calculations by Chris Giles, which I have attempted to replicate, which demonstrate that price inflation has been higher for households at the upper end of the income scale because their spending basket has shown a faster inflation rate than for those lower down the scale. On my calculations, the inflation rate for households in the lowest income decile was 5.3% in December versus 5.8% for those in the highest decile.

None of this is to say that we can ignore the distributional aspects of inflation. The rise in the energy price cap will almost certainly hit households at the low end of the income scale disproportionally hard. This raises a question of what, if anything, should be done about it? The financial market response is clear – central banks should raise interest rates, and they probably will, but it is unlikely to have any impact on a supply-driven inflation shock. Indeed central bankers find themselves in an impossible situation. If they don’t raise rates at a time when inflation is overshooting target by a wide margin, the future credibility of inflation targeting regimes will be compromised. Against that, if consumers are facing a cost of living crisis in which real income growth is being eroded by exogenous price shocks, monetary tightening is more likely to exacerbate these concerns.

As MPC member Catherine Mann pointed out in a speech last week, the evidence suggests that the recent inflation surge is not based on a narrow range of goods and services but is increasingly looking more broad-based and “has seeped into those [components] that typically are rather stable.” She also pointed out that “Bank research shows inflation expectations tends to be correlated with wage demands, and that items that consumers buy frequently, such as energy, food, and clothing have particular salience for their short-term perceptions of inflation.” A gradual tightening of monetary policy to offset the threat of a wage-price spiral would thus appear to be a prudent move.

Alternative ways to tackle the energy inflation problem

However, it seems clear that monetary policy is only going to be part of the solution in the near-term. One temporary fix to offset the inflationary impact of higher energy prices might be to zero-rate domestic fuel bills for VAT purposes (in the UK it is currently charged at a rate of 5%). It would come as no surprise if this measure were to be announced in the spring budget in March. Another option might be to remove the green levy on household fuel bills, and instead fund them out of general taxation. At present, the Energy Company Obligation (ECO) requires medium and larger energy suppliers to fund the installation of energy efficiency measures, which is charged back to the consumer via their energy bills (primarily electricity). Permanently scrapping the ECO would obviously reduce energy bills, and thus inflation, but would require an increase in taxation elsewhere to fund the shortfall. This problem could be mitigated if the ECO were scrapped for just a year.

One downside with these solutions is that they would benefit both poor and wealthy households and do little to tackle inequality issues. Amongst the alternatives that have been floated are the extension of existing government-funded support to those on means-tested benefits or simply restoring the uplift to Universal Credit that was put in place during the pandemic but taken away in October. Whilst these measures will do nothing to tackle rapid price inflation in other areas they may help to avoid the worst case outcomes in 2022.

Unpleasant choices ahead

Nonetheless, we are likely to be faced with a series of unpleasant choices in the months and years ahead and tinkering with the tax and benefit system is unlikely to resolve them. On the one hand we will likely have to face up to higher taxes as governments attempt to claw back some of the fiscal costs associated with the pandemic. As it is, UK national insurance rates are set to rise in April, at the same time as the energy cap is due to increase. There is also a wider issue associated with the transition to green energy sources. If we are serious as a society about making this transition, there will be a price to pay and consumers will ultimately have to bear it.

Although the pressures on consumer incomes are particularly great at present, and will undoubtedly diminish with time, we may not return to the nirvana of strong income growth and low price inflation anytime soon (at least, not without a recovery in productivity growth to something like pre-2008 rates). The transition to the post-Covid economy may prove to be more painful than anticipated.

No expectations

Inflation remains one of the big items on the policy agenda with the IMF’s latest World Economic Outlook devoting a considerable amount of space to the topic, warning that “central banks should remain vigilant about the possible inflationary effects of recent monetary expansions.” In fairness the IMF does use the stock phrase beloved of policy analysts that “long-term inflation expectations have stayed relatively anchored.” However this comes at a time when parts of the macroeconomics profession are beginning to question just how much we really know about the inflation generation process, with the role of expectations coming under particular scrutiny.

Like many areas of economics the forces underpinning inflation have been subject to various fads over the years. Between the 1950s and 1970s, attention focused on the labour market and the role of the wage bargaining process. During the 1980s monetary trends were the flavour of the period but over the last 25 years the main area of focus has been the deviation of output from the NAIRU and the determination of inflationary expectations. Given the change in fashions over the years, it is difficult to take seriously the idea that there is a generic theory of inflation: like theories of the exchange rate, different factors drive the process at different times.

For my part, I have long harboured doubts about the way macroeconomics treats inflation (see the posts Do we know what drives inflation? from August 2017 and Monetary policy complications from October 2017 for more detail). It was thus heartening to see that economists at the Federal Reserve share similar reservations. In a highly readable paper published last month, which received considerable media exposure, Jeremy Rudd of the Fed staff posed the question ‘Why do we think that inflation expectations matter for inflation? (and should we?)’

As the paper’s abstract noted, “A review of the relevant theoretical and empirical literature suggests that this belief [in expectations] rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.” Rudd goes on to describe competing models of inflation used by macroeconomists over the past 50 years and concludes that the use of expectations to explain inflation dynamics is both unnecessary and unsound. In his view it is unnecessary because it can be explained more readily by other factors and unsound because it is not based on any good theoretical and empirical evidence. Moreover, the theoretical models are influenced by short-term (usually one period ahead) expectations, which “sits uneasily with the observation that in policy circles … much more attention is paid to long-run inflation expectations.”

The empirical evidence suggests little evidence of a direct effect of expectations on inflation. According to Blinder et all (1998)[1], “what little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a pre-emptive fashion.” Evidence from the Atlanta Fed survey of business inflation expectations over the past decade confirms that expectations have been remarkably constant until relatively recently with unit costs one year ahead generally expected to grow at an average rate of 2% (chart). However, it is notable that during 2021 there has been a sharp pickup as the economy suffered bottlenecks in the wake of the pandemic.

The standard central bank view of inflation expectations was highlighted in a 2019 speech by BoE MPC member Silvana Tenreyro. It is a perfectly fine piece of conventional economic analysis as befits an orthodox central bank economist. She noted that household inflation expectations are a key input into the BoE’s thinking, arguing that for any given interest rate, higher inflation expectations increase households’ incentive to spend today rather than saving. But once you start digging below the surface, the argument rests on some weak foundations. For example, the evidence from both the US and UK suggests that households consistently expect CPI inflation to average close to 3% at horizons of between one and five years ahead. In other words, despite the best efforts of central banks, households continue to expect inflation to run above their target rate. Tenreyro was also forced to concede that “households do not always adjust their expectations even when prices start rising more quickly or slowly than they had expected” which really ought to raise some questions about their usefulness.

A more serious criticism of inflation expectations came from Rudd who pointed out that “the presence of expected inflation in these models provides essentially the only justification for the widespread view that expectations actually do influence inflation … And this apotheosis has occurred with minimal direct evidence, next-to-no examination of alternatives that might do a similar job fitting the available facts, and zero introspection as to whether it makes sense.” Instead Rudd offers the explanation that the absence of a wage-price spiral is one of the key defining features of recent inflation dynamics. He goes on to suggest that “in situations where inflation is relatively low on average, it also seems likely that there will be less of a concern on workers’ part about changes in the cost of living … But this is a story about outcomes, not expectations.” In other words, when inflation is below a certain threshold level workers stop pushing for bigger wage hikes which has contributed to keeping inflation low – unlike in the 1970s.

This has a number of important policy implications:

• First, it will be important to keep an eye on whether wage settlements are responding to higher price inflation. 
• Second, because central bank economists, who are influenced by latest academic thinking, generally tell policymakers that “expected inflation is the ultimate determinant of inflation’s long-run trend, [they] implicitly provide too much assurance that this claim is settled fact. Advice along these lines also naturally biases policymakers toward being overly concerned with expectations management, or toward concluding that survey- or market-based measures of expected inflation provide useful and reliable policy.” 
• Third, precisely because inflation dynamics are influenced more by outcomes than expectations, “it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “reanchor” expected inflation.” 
• Finally, “using inflation expectations as a policy instrument or intermediate target has the result of adding a new unobservable to the mix. And … policies that rely too heavily on unobservables can often end in tears.”
  

Even if you do not accept Rudd’s premise (and many mainstream economists do not) this is an important contribution to the debate. One of the criticisms being bandied around as the economy rebounds from the 2020 collapse is that there is insufficient diversity of thinking around some of the key underpinnings of mainstream macro. If nothing else, Rudd forces us to think more critically about how we think of inflation and our understanding will be all the stronger for it.

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[1] Blinder, A., E. Canetti, D. Lebow, and J. Rudd (1998). ‘Asking About Prices: A New Approach to Understanding Price Stickiness’. New York: Russell Sage Foundation.

Not the 1970s but not the 2010s either

Inflation concerns have been rising up the market agenda during the course of this year. These fears appeared justified following last week’s release of US CPI inflation data which showed a jump from 2.6% in March to 4.2% in April – the highest rate since September 2008. This week’s UK release also showed a big jump in CPI inflation from 0.7% in March to 1.5% in April, and whilst the pickup in euro zone inflation was more modest (to 1.6% from 1.3% in March) it is now at its highest in two years. Obviously there are base year effects at work with last year’s total shutdown in activity making price measurement in April 2020 extremely difficult. Nonetheless, there are indications that price pressures are building. How worried should we be?

Dissecting CPI inflation data reveals the extent to which it has recently been driven by the recovery in oil prices. Recall that in April 2020 the price of Brent dropped to a monthly average of $18 versus $64 in January and $56 in February and whilst it subsequently recovered, it was only in February/March 2021 that oil got back to pre-pandemic levels. But whilst US core CPI inflation stood at only 3% in April – more than a percentage point below the headline rate – it was still almost double that in March and its highest in 25 years. On the basis of price trends further down the chain, consumer prices are likely to rise further. Aside from oil, industrial metals such as copper have reached record highs whilst there have been well-publicised warnings that shortages in key industrial components such as semiconductors will also push up prices. A further warning sign is that Chinese producer prices are now running at their fastest pace since late-2017 (6.8%) suggesting that price pressures in the workshop of the world need to be viewed with caution.

In addition to the base year effects, the inflation pickup in 2021 reflects the concerns expressed a year ago that the damage to the supply side of the economy during the lockdown would generate a pickup in inflation as capacity bottlenecks emerged. If this is the case, then surely the recent resurgence in inflation will prove temporary. This is not to say we will not see a further big rise to levels which many people might think scarily high, but it does suggest that we are not on the verge of a 1970s rebound. To the extent that inflation is driven by the difference between what economies consume and what they can produce (the output gap), and given that output gaps across the OECD remain in negative territory, suggesting that there is plenty of capacity to accommodate any pickup in demand (the average across the OECD is estimated at -5.2% in 2021 - see chart below), there is no obvious sign that a sustainable burst of inflation is in the offing.

It is true that lax monetary policy has helped support the rebound, leading in effect to a monetary-induced burst in inflation, but the expectation is that this will be temporary. As the demand catch-up from 2020 begins to fade, so it is widely expected that demand-supply pressures will ease and price inflation will slow (hopefully back towards central bank targets). The likes of the BoE have adjusted to this by slowing the pace of asset purchases although it has not adjusted the overall target for the stock of asset purchases which is ultimately what matters for the degree of monetary easing. 

Although it is expected that inflation in the UK and US will overshoot the central bank’s central 2% target we should view this in part as a consequence of the post-pandemic adjustment process. Indeed, there is likely to be a change in the product supply-demand mix which will leave an overabundance of productive capital tied up in areas where demand has declined, whereas there is a shortfall in areas where demand has increased. Accordingly we might expect strong inflation in some classes of goods and services, whereas in others it is weaker, which might persist for some time until the demand-supply balance has been restored.

Central bankers will thus be closely watching inflation expectations for some time to come for indications that it is set to take off. But inflation expectations differ according to who we ask. For example, the BoE’s survey of UK households shows that they have consistently overestimated expected inflation over the past 20 years. There is thus a strong argument for attaching a low weight to household expectations. In any case, households have limited bargaining power when it comes to setting wages so their weight in the price setting process is limited. Moreover, financial literacy amongst many households is not as high as it could be with the result that the concept of inflation is often hazily defined. Much of the academic literature thus attaches greater weight to the expectations of companies and those priced into financial markets. From a financial market perspective there has been a small pickup in inflation expectations, as derived from 5y5y swaps in the US and euro zone (chart below), but it is no higher than at any time in the last five years. Nor does corporate survey evidence across the industrialised world suggest that a pickup in wage inflation is likely anytime soon.

For all these reasons, some of the more lurid headlines suggesting that we may be on the brink of a 1970s-style inflation pickup are likely to be wide of the mark. There appears to be plenty of spare productive capacity; inflation expectations remain well anchored (for the moment); the ability of organised labour to push for higher wage claims is much more limited than it was 50 years ago plus – and this is perhaps the critical difference – in an increasingly global economy, inflation is a function of world rather than local conditions. None of this is to say that inflation will not run above target. The BoE, for example, looks for a UK inflation rate above 2% until around autumn 2022 although crucially it is not expected to exceed the upper 3% band.

If, however, we are about to experience higher inflation there is also a case for taking away some of the extreme monetary easing put in place over the last year. Over the last decade, central banks have used the argument of low inflation as a reason for keeping the pedal to the metal. Above-target inflation surely warrants a move in the other direction.

A new monetary paradigm

Last week marked a big event in central banking history and economists will look back at Jay Powell’s speech on 27 August as the point at which the parameters of the three decade experiment with inflation targeting were changed. Central banks have tended to adopt a numerical target for inflation, usually centred around 2%, but in recent years inflation has undershot this target. A variety of reasons have been put forward for this. Many central bankers will argue that the adoption of inflation targeting was one of the factors which squeezed the high inflation of the 1970s and 1980s out of the economy. However, we can also add a number of exogenous factors such as the opening up of China as the workshop of the world, the end of the Cold War and more flexible labour markets.

Whatever the reason, there is a strong case for suggesting that the current regime which emerged in the wake of the high inflation of the 1970s and 1980s is no longer appropriate. For one thing, as currently practiced, inflation targeting contains an inbuilt asymmetry since central banks are more likely to react to inflation overshoots rather than undershoots for fear of being seen as soft on inflation, despite the fact that the target usually allows for some leeway around the central case. But we find ourselves today in an environment in which economies have taken the biggest hit in at least 90 years and inflation concerns are rapidly being put on the back burner as policy makers start to concern themselves with issues such as unemployment. Accordingly, the Fed announced last week that it will in future target maximum employment and “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” In effect, it will adopt a medium-term price level target – something many economists have devoted time to thinking about over the past decade.

This has a number of important implications for monetary policy in future. For one thing it effectively means that the Fed will be less likely to pre-emptively tighten policy in response to a perceived inflation pickup after a period of below-target inflation. At a time when real economy concerns are paramount this makes a lot of sense. But questions arise as to what the Fed means by the two parts of the phrase “inflation moderately above 2 percent” and “for some time?” Much of the early discussion about price targets tended to focus on short-term deviations of inflation from the target. Thus if an exogenous shock results in inflation averaging 1% over a year, inflation can run at 3% the following year in order that it averages 2% over the whole period. But if inflation averages 1% over a 10-year period, this would require a 3% rate over the next ten years in order to get the long-run average inflation rate back to 2% (chart). In such a case is 3% “moderately above 2%?” And does a ten year period represent “some time” or does this represent a whole different paradigm?

As I argued in this post once we start to tolerate higher inflation the concept of price stability begins to become eroded. There is thus a concern that the price level targeting regime could result in inflation expectations becoming de-anchored. We might not worry about this any time soon but it is a discussion which will doubtless be taking place within the Fed. That said, at a time when government debt levels have gone through the roof in many countries, no government is going to complain about a little bit more inflation if it helps to alleviate the debt burden.

One of the less discussed aspects of the change was that on the rules versus discretion spectrum, which has been a feature of monetary policy over recent decades, the Fed’s policy announcement is very much a step in the direction of discretion. It ascribes a greater weight to “the shortfalls of employment from its maximum level” where the Fed freely admits that “the maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time.” Full employment has always been a nebulous target, but it is about to become even more so and runs the risk of being whatever the Fed believes it to be in order to satisfy its current policy stance. For markets which have become used to interpreting mechanistic rules, this implies a rather more opaque central bank than we have become used to. It also suggests an enhanced role for forward guidance which is likely to become even more important as a policy tool.

Another important aspect of the new policy is that the central bank will be even less concerned in future with trying to fine tune the economy via monetary policy, since shortfalls imply a persistent deviation from the nebulous concept of maximum employment whereas deviations imply cyclical divergences. Whilst the Fed’s moves make a lot of sense from an inflation perspective, it also fits with the new realities of the post-Covid economy in which central banks will have to play their part in dealing with the resulting economic scarring. By explicitly committing to keeping rates low(er) for longer, the Fed is perhaps taking the first steps along the path towards financial repression. 

However, it is important to be aware of some of the downsides. For one thing a policy of targeting price levels implies the potential for short-term inflation volatility if economic agents are not sufficiently forward looking and base their inflation expectations on extrapolation of current rates out into the future rather than the longer term goal of ensuring that price levels will eventually return to target. In addition, the standard objection in the literature is that there is likely to be greater output volatility under a price level targeting regime as the central bank does not attempt to moderate cyclical swings as frequently.

Nonetheless, it is likely that other central banks will eventually follow in the Fed’s footsteps and adopt a version of an average price level target with a focus on the real economy. However, it is unlikely to find much favour in the euro zone where the focus on short-term price stability remains paramount. But as Martin Sandbu points out in the FT the ECB has “treated its own legal mandate far too narrowly … There is a widespread misperception that the ECB is treaty-bound to the single duty of ensuring price stability … But beyond this, the ECB has a legal obligation to ‘support the [EU’s] general economic policies’” (a point I have made repeatedly in the case of the BoE). The ECB may not be a slave to monetary policy fashions but it is not the Bundesbank and has proved itself pretty flexible in its monetary dealings in the past. It just might take a while to get there.