Central banks should keep inflation in check

During the pandemic, US and eurozone central banks reformed their monetary policy strategy in a major break from previous practice. After a decade of below-target inflation and an achingly long lull in employment to regain previous highs, rate-setters promised that inflation would temporarily stay above target as long as continued monetary stimulus was warranted.

With several nasty surprises on the supply side, this should have steeled central bankers’ nerves. And for a while, they kept their cool during the resulting burst of inflation. But they have not kept up the courage of their new conviction. Instead, they allow criticism to urge them to dismiss the possibility that high demand pressures could draw more resources into the economy than previously thought, thus helping to contain price pressures over time while maintaining growth.

Central banks now seem determined to restore this monetary version of the toxic machismo that says it doesn’t work if it doesn’t hurt. Political leaders are increasingly emphasizing that they intend to bring down inflation, even at the cost of slowing growth or putting people out of work. Markets have stuck to their cue and are preparing for recessions.

Of course, the central bankers are not happy about that. Her case rests on the notion that there is no better alternative. But if so, they should be absolutely right and unfortunately their argument is weaker than many think.

First, the increase in inflation was almost universally attributed to supply shocks. But despite the obvious role played by Vladimir Putin’s attack on Ukraine and the subsequent gas supply shortage, the prevailing view has somehow shifted to blaming excessive demand.

But it was only this year that nominal spending topped the pre-pandemic trend in the US; and this has still not happened in the UK or the eurozone. Even in the US, the total volume of goods and services purchased (as opposed to their market value) is right on trend before the pandemic. So not so much demand running amok as a recovery in demand (itself a triumph of crisis policies) confronted with higher prices for supply-side reasons.

The obvious response is that even if demand is near normal, supply may not be, either because of the pandemic or because of energy and commodity price spikes. But how sure can we be that these are permanent problems? (There’s little point in triggering a recession to deal with temporary supply shortages.)

The pandemic could have affected the economy’s productive capacity by reducing the number of healthy workers. But not in the eurozone, where many countries have record high employment rates. And while the US economy still employs nearly a million fewer people than it did in February 2020, the current boom continues to create jobs at a rate more than double the pre-pandemic average. Employment growth also remains strong in continental Europe.

There is little sign of this fizzled out. But central banks could stall it with their determination to curb demand growth. So the question is: do our economies really need fewer people in the workforce now? Against the background of inflation, isn’t it necessary to let employment and thus supply continue to grow strongly in order to reduce price pressure in the long term?

The same applies to the energy crisis. Economies that import net energy are impoverished by high oil, gas and electricity prices, requiring them to export more and consume less to meet their energy needs. How is this problem mitigated by also reducing domestic production when contractionary policies hit both employment and investment? (For countries that are not net importers, higher energy prices create inequality that tightening monetary policy can only exacerbate.)

The final argument for tightening into a supply-side recession is to avoid a wage-price spiral. But the rationality of this depends on the risk being more than theoretical. Wage increases are, of course, welcome in and of themselves – and robust profit margins suggest that labor costs are not driving up prices. It is also worth noting that the countries with the largest collective bargaining coverage (France, Italy, Scandinavia) have the lowest inflation rates.

None of this should diminish the real suffering being caused by the cost of living crisis. But a monetary contraction on the cusp of a recession will make things worse to no avail. Governments must provide support to those most affected by the price jump. But perhaps, for the sake of monetary and economic stability, central banks should treat inflation with benign neglect. Central banks should keep inflation in check

Adam Bradshaw

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