Inflation and Our Discontents

As 2022 progressed, the Covid pandemic, though far from vanquished, was overtaken in the popular mind and government agenda by the other feared zombie – inflation! From a world of near and below zero interest rates, quantitative easing  and massive government spending, the world’s central banks, led by the US Federal Reserve began to slam on the brakes. Official interest rates were progressively hiked in large quanta month on month. Financial markets followed like sheep as the whole structure of credit instruments were rapidly repriced. Asset markets moved in the opposite direction as share prices and real estate values fell. The economics profession bifurcated, with some arguing that inflation was now structurally embedded, while other saw it as transitory, the result of current contingencies emanating primarily from supply-side shocks caused by the pandemic and the energy crisis trailing Putin’s invasion of the Ukraine, boosted temporarily by consumers tapping into forced savings built up during the restricted period of recurrent lockdowns.

The question for the team temporary, as commentator Paul Krugman terms them, is how transitory. The pandemic is still criss-crossing the world, merrily mutating ahead of vaccine and drug defences, while Putin continues to ratchet up the war. The question for team permanent is how long and how hard should the central banks go on raising interest rates; in other words, how long before the world’s economies crash into recession or worse?

It’s clear in hindsight that the central banks were slow to overreact to the pandemic and war. Rates were kept too low for too long, especially in light of the necessary massive fiscal stimuli administered to national economies to keep them from sparking another  great depression. The current danger is that the banks are in the process of making the reverse mistake – late starting, they are now keeping rate too high for too long as national governments strive to bring their budgets back towards balance. 

A further complication follows from the uneven pattern of inflationary forces traversing the world. Inflation risk is higher in some countries. The supply shocks are especially sharp in Europe as a result of Russian gas constraints. European economies totter on the edge of recession and Britain has already fallen into it, while contemporaneously also experiencing cost-push inflation associated with rising energy costs, not wages. High inflation in the United States continues to capture the interest of the Federal Reserve, though Krugman and followers claim to see inflation moderating. In Australia, with inflation at around 7 per cent, the Reserve Bank continues to follow the US lead and is poised to raise interest rates for a ninth time in a year.

But since inflation virtually everywhere is of the cost-push rather than demand-pull variety, why it might be asked are governments relying on suppressing demand – that is, consumer spending and private investment? The answer is, depressingly, because they and their central banks can’t do anything else. The only instrument they can turn to is manipulation of interest rates, a very blunt instrument indeed. Alternative approaches like price controls and taxes would breach the orthodox verities of macroeconomic policy. More radical restructuring of the economy to break monopoly power and reduce economic inequality would threaten the political and ideological grip of dominant elites. What we are left with is a self-reinforcing feedback loop between inflation and inequality resulting in real wages stagnating or falling and the wealth of privileged classes accumulating. Asset inflation in real estate, company shares, and other stores of value is accompanying price inflation in a merry gig. The two partners are closely linked, as housing costs make up more than a third of the consumer price index in most countries.

But stepping back, the whole inflation story looks more and more like a fable, an invention designed to keep the masses in their place. Yes, your real standard of living is falling. Yes, your children will be less well off than you. Yes, we at the top are alright (we’re doing okay). But it can’t be helped. It’s all due to the threat of inflation. We have to kill the beast before it devours us all. Trust us, we have the matter in hand. All will end happily. Unfortunately for the tellers of this tale, the masses are getting restless. Populist dissent is growing. Populist leaders are emerging to ferment and ride this mood. The dangers of populism to democracies are well attested in history. Populism once unleashed is much more difficult to curb than individual populists like Trump, Johnson and Bolsonaro .

So, let’s look a little more deeply at the phenomenon of inflation. Every school child has heard about the great hyperinflation in Germany in the 1920s. Images of people taking wheelbarrows of worthless notes to buy a loaf of bread resonate the collective memory. More recently runaway inflation has occurred in South America and other places, though not to the extent of Weimar Germany. Hyper-inflation is certainly a fearful thing. In Germany it wiped out the middle classes and provided fertile ground for the growth of hyper-nationalist politics ending in the rise of fascism. But it should be remembered that the German experience was an historically specific event, in part deliberately contrived to force revision of the punitive reparations clauses of the Treaty of Versailles. The wheelbarrow experience is not the inevitable fate of moderate increases in prices across an economy.

So why have governments reacted so savagely to the moderate inflationary bump over the last year? The answer lies not in Weimar weeds but much closer to our time – to developments in economic theory and policy during the 1970s. The simultaneous coupling of increasing unemployment and inflation undercut the post-War Keynesian approach that posited a stable relationship between these two key variables. If inflation tipped upwards, then restrictive monetary and fiscal policy could nudge the economy back to stable growth. If unemployment rose, expansionary policy resulting in rising prices could increase growth relieving pressures on prices. If both started rising and showing no tendency to moderate policy makers were left to choose which variable to target. Monetarist economists like Milton Friedman argued that it was most important to break the inflationary dynamic lest it spiral out of control. He further claimed that government interventions aimed at reducing unemployment would only exacerbate matters as rising wages in tightening labour markets were passed on to prices sparking further attempts by workers to ‘catch up’. It would be a case of the cat chasing its tail. Further refinements to the argument painted the tail overtaking the cat as workers and employers began to pre-emptively anticipate future price rises. Responsible policy focused on breaking the inflationary expectations before they got a hold – initially by controlling the supply of money in the economy and when that proved too difficult (which measure of money supply?) by means of restrictive interest rates alone. As soon as inflation showed its face the central bank would be called upon to reassure financial markets by raising rates.

But how to recognise inflation’s face and thus the point at which decisive action was required. The answer, theoretically, came in the form of the NAIRU – ‘the non-accelerating inflationary rate of unemployment’.  At some point, it was claimed, the unemployment rate would fall below a critical point after which wages and prices would both begin to accelerate. Governments had to ensure this didn’t happen. Since elected governments and their oppositions were prone to over-egg the economy in order to get (re)elected, it was thought wise to charge an independent central bank with the job of hitting the NAIRU. Unfortunately, no one had any idea what the NAIRU was. It has been variously set at 8, 6, 7, 3, 4 per cent over recent decades. There has been a tendency for the figure to chase recent trends in unemployment. This embarrassing situation has caused central banks to set a price inflation target as the basis of macroeconomic policy. The Federal Reserve, following the experience of the late 1970s and early 1980s, has opted for a target rate of  2 per cent, intervening (or threatening to) when prices rose faster than that. In Australia, the Reserve Bank operates with a slightly more flexible 2-3 per cent band. There is no firm rationale for either target – why not pi (π) or 4 per cent or my dog’s age? – because, to repeat, no one knows what the NAIRU is. So, the bank errs on the cautious side of life. This has the effect generally of dampening growth below the productive capacity of the economy, making living standards grow more slowly over time for a large majority of households than a more selective and less restrictive policy regime would encourage. Thus, the savage program of interest rate rises imposed at the end of the seventies to put a brake on inflation cost Americans dearly. Something similar happened in Australia a decade later as interest rates were jacked up to the point where new mortgage borrowers were paying rates at more than 17 per cent. Why? In order to bring on (in the words of Labor Prime Minister Paul Keating) ‘the recession we had to have’.

It turns out that an inflation target is as dodgy as trying to track the money supply. The Consumer price index is a statistical fiction, representing a supposedly typical basket of goods and services consumed by the average consumer, whoever that might be. Adjustment to the basket must be made from time to time to try and capture the expenditure patterns of this mythical beast. But what to include (and exclude)? Paul Krugman in his New York Times commentaries has noted seven alternative measures of the index (I won’t name them; you can chase them up if you wish). Depending on what classes of items are focused on inflation measure can vary widely, hence the difference between headline and core inflation (two of the seven measures) you read about. All the measures bounce about month on month, so tracking rolling quarterly  averages tends to be more  useful than individual monthly and annual figures. But this doesn’t do away with the problem of data lag, the fact that central banks are looking in the rear view mirror at inflation measures that are months in the past. Thus, the bank tends to use a suite of indices and measures to get a jump on inflation, further reason for caution that reinforces the inertial trajectory of policy. Monetary policy as the only game in town is more art that science, a juggling act where judgment as well as talent counts. And, as recent Australian experience shows, sometimes the juggler drops the balls.

At base, conventional inflation fighting is all about power – monopoly power to increase prices and political power to keep wages down. ‘Independent’ central bank monetary policy has been one of the key policies – along with privatisation, deregulation, outsourcing and anti-government and anti-union rhetoric – that drove the neoliberal project over the past four decades.

Surely it is not beyond the wit of man and woman to find a better way to ‘fight inflation’ without so much collateral damage to ordinary people. Is a general economic recession, globally transmitted, the inevitable result of our attempts to date to navigate the great pandemic? Can’t the structural tendencies to stagflation be better addressed by a broader suite of macroeconomic policies targeting monopoly power and entrenched inequality?

I hope so, but I’m not confident – are you?