The world’s central banks may lack the necessary tools to control inflation this time around. Yet despite their strident denials, rising prices in fact might be consistent with their objectives.
Contrary to central bank messaging about low- and transitory inflation, consumer prices are rising globally in the U.S. (7% annually), Canada (4.8%), the U.K. (5.4%), Australia (3.5%) and New Zealand (4.9%), to name a few.
Inflation is always about demand and supply. Nowadays, demand has been underpinned by low interest rates, central bank liquidity and fiscal expansion financed by quantitative easing. Central banks have injected more than $32 trillion (equivalent to buying $800 million of financial assets every hour for the past 20 months). Some of this often poorly targeted support has been excessive, substantially exceeding declines in income. Infrastructure spending and industry incentive have exacerbated the problem.
Both short- and long-term supply issues have boosted prices. Oil prices have risen four-fold since the artificial lows of 2020. Energy politics combined with a poorly planned and executed energy transition to renewables are key factors. Higher food prices reflect extreme weather, especially droughts and floods and national stockpiling.
The COVID-19 pandemic has disrupted labor availability and production. A zero COVID policy in China, the world’s factory, has meant periodic interruptions of production and port traffic. Transport links have been affected, resulting in higher prices, delays and increasing unreliability. Diversion of resources to address the virus has created shortages.
COVID has increased cost structures. Debt incurred to cover revenue shortfalls must be paid for in higher taxes, where incurred by governments, or income, in the case of businesses. Businesses face rising expenses to meet COVID-relatd public health regulations. The lasting effects on worker mobility and labor costs remains uncertain.
One ignored factor is geopolitics, particularly the Sino-American economic war. Trade restrictions and sanctions combined with hoarding and re-shoring production has affected everything from PPE, semiconductors, rare-earth minerals and technology transfers. This has reduced availability and pushed up prices.
In dealing with price pressures, monetary policymakers face several complications. Traditional economic models such as the Phillip’s Curve, which describe the trade-off between unemployment and inflation, have proved deficient in recent times.
Managing spending and demand
Available tools mainly act on demand. Winding back government spending, increasing rates and reversing loose monetary policies may curtail demand. But the risk is that an economy addicted to stimulus will stall out, compounding other problems. Rising interest rates are even more problematic. With inflation running high, rates would have to climb sharply to be an effective deterrent.
In the “everything bubble,” higher rates could trigger sharp declines in asset values, especially homes and stocks, far beyond the relatively modest market corrections experienced since late 2021. It would also result in increased debt-servicing costs on government, business and household debt, especially mortgages.
The adverse effects on investor wealth and confidence would hurt economic activity. The greater impact would hit the financial system, where asset prices act as collateral for high levels of borrowing and low rates allow borrowers to meet interest payments. Borrower financial distress risks a new financial crisis, with the familiar regime of bailouts and measures to continue the flow of credit to keep the economy going.
Policy options on the supply side are limited. Interest rates and quantitative tightening cannot control the virus and extreme weather or bridge geopolitical divides. Government spending may help rebuild essential infrastructure and correct workforce shortcomings, but that will take years. Inflexible global supply chains are expensive and take time to redesign. The alternative — maintaining larger buffer stocks — is also costly.
“Rising prices would help increase consumption, as buyers accelerate purchases out of fear of ever-higher costs.”
Central bank attitudes to inflation are complex. Having spent much of the past two decades avoiding deflation, toleration for inflation may be greater than publicly expressed. Rising prices would help increase consumption, as buyers accelerate purchases out of fear of ever-higher costs. Higher inflation is also key to dealing with the high levels of debt over the long-term. It would increase taxes and business revenues and reduce purchasing power, which lowers real debt levels.
For ordinary households, limited bargaining power, lower levels of unionization, the ‘Uberization’ of the workforce and substitution of labor with automation (accelerated by the pandemic) mean that wage hikes will not keep pace with inflation. This will lead to lower living standards for citizens and hurt society’s poorest and most disadvantaged people.
Moreover, with the only thing decreasing being asset prices, investors face difficulties. Chronic overvaluation, possible declines in both risky assets and bonds, and tighter liquidity, all limit investment choices. Certain options, such as real assets, are available, but preserving capital and purchasing power will be challenging.
Former German Central Bank President Karl Otto Pohl has compared inflation to toothpaste: Once out of the tube, it is difficult to put back. As policymakers, citizens and investors are all about to find out, it also makes quite a mess.
Satyajit Das is a former banker. He is the author of “A Banquet of Consequences – Reloaded: How we got into this mess we’re in and why we need to act now.” (Penguin Random House Australia, 2021) and Fortune’s Fool: Australia’s Choices (Monash University Publishing, March, 2022)