In August 2020, Jerome Powell, the chairman of the Federal Reserve, outlined a change in the central bank’s policy framework. “The economy is always evolving,” he noted. “Our revised statement reflects our assessment … that a strong labor market can be sustained without causing an unwanted increase in inflation.” It was a pivot informed by a long period in which prices so often rose less than the Fed preferred and more.
Two years later, the Fed faces very different conditions: peak unemployment, strong wage growth and inflation rates well above the central bank’s target. On August 26, at an annual jamboree for central bankers in Jackson Hole, Wyoming, Mr. Powell sang a different tune. “Without price stability, the economy doesn’t work for anybody,” he said, adding that the Fed is willing to impose economic pain to get inflation back on target. How many might be required remains anyone’s guess. But the economists and policymakers gathered beneath the Teton Mountains repeatedly expressed a serious concern: that the global forces that in recent decades have helped keep inflation low and stable may be weakening — or reversing.
To misquote Milton Friedman, inflation is often and primarily a monetary phenomenon. Central banks have many tools at their disposal to curb spending in an economy, and thus prevent demand from outstripping supply. But they do their job in an evolving economic environment, which can make it easier to smooth out price pressures at some times than others. From the 1980s onwards, inflation in the rich world generally declined and became less volatile. The phenomenon is usually attributed to better monetary policy, but also to favorable global conditions relative to those faced by central banks in the 1960s and 1970s, when economies were hit by falling productivity, happy governments and energy shocks. The world may now be “on the brink of historic change,” as Agustín Carstens of the Bank for International Settlements, a central bank club, put it in Jackson Hole.
Worriers see a few reasons why inflation may remain high. Government spending and borrowing patterns seem to have changed, for one. Across rich and emerging economies, public debt burdens have skyrocketed over the past two decades. As debt burdens rise, markets may begin to fear that central banks will eventually have to help finance governments’ obligations, say by creating new money to buy bonds. This could erode the central bank’s credibility and raise public expectations of future inflation.
Fiscal firepower built up during the pandemic may also reflect governments’ greater openness to using stimulus to fight recession, which could also prompt markets to expect more spending and inflation going forward. Papers presented at the conference by Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Federal Reserve Bank of Chicago suggested that US inflation was about four percentage points higher than it would have been otherwise, thanks to “fiscal inflation” that related to the $1.9 trn stimulus package approved in 2021.
Workers are also scarcer. Population growth in the rich world has slowed dramatically due to demographic change and lower immigration. In some economies, such as America, the pandemic has been linked to further declines in labor force participation. From the 1990s to the 2010s, the global labor supply expanded rapidly as populous economies such as China and India became better integrated into the global economy. But that experience cannot be repeated and aging is starting to hit the labor supply in parts of the emerging world as well. Workers may thus enjoy more bargaining power in the future, pushing up wages and making life harder for inflation-fighting central banks.
Then there are slow changes in the structure of the world economy. Both emerging and advanced economies engaged in a wave of liberalizing reforms from the mid-1980s to the mid-2000s. Tariffs were lowered, while labor and product markets became looser. These reforms contributed to a boom in global trade, large-scale changes in global production, and cost reductions in a range of industries. The reform may also have boosted productivity growth, which accelerated in advanced economies at the end of the millennium and in emerging economies in the 2000s. But the pace of reform slowed and productivity growth declined after the global financial crisis of 2007– 09, while trade was under constant pressure from trade wars, the pandemic and geopolitical tensions. Globalization served as a “giant shock absorber” from the 1980s to the 2010s, noted the European Central Bank’s Isabel Schnabel, so that changes in demand or supply were easily dealt with through corresponding adjustments in output, rather than with wild price fluctuations. Now that flexibility is at risk.
Nowhere to run
For the central bankers in attendance, this was heartening. But it doesn’t have to be revealing. Some trends could make a new macroeconomic era a little easier. Demographic change can go both ways, as the IMF’s Gita Gopinath noted. While workers in aging economies may be scarce, they will also save more, helping to moderate inflationary pressures. And as those at the symposium discussed, the changes brought about by the pandemic may pay yet another productivity dividend.
Most crucially, there is less mental confusion today than in the 1970s. As Mr. Powell noted, central bankers once needed to be convinced that they could and should bear responsibility for the level of inflation – a situation that allowed high inflation to rage for more than a decade. Today, by contrast, the Fed’s “responsibility to provide price stability is unconditional.” Central bankers are beginning to accept that their task may be more difficult in the coming years. This realization alone could prevent a new era of shock and instability from being truly catastrophic.
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From The Economist, published by permission. Original content at https://www.economist.com/finance-and-economics/2022/08/30/central-bankers-worry-that-a-new-era-of-high-inflation-is – principle