I think most people
understand that the inflation we are seeing at the moment across the
developed world has very little if any to do with excess demand (the
famous too much money chasing too few goods) but is about external
shocks to the price of commodities, and supply problems that emerged
because of the pandemic and the recovery from it. In addition both
types of inflationary shock are likely to be temporary: commodity
prices are unlikely to continue to rise and most supply problems
caused by the pandemic will be resolved.
If this is the case,
why do central banks need to raise interest rates, particularly as
higher commodity prices will reduce real incomes which is
deflationary? Given the normal lags in monetary policy, higher rates
will have little impact on current inflation, so why reduce demand
and inflation in the future when inflation has largely disappeared?
The answer is fear of a wage-price spiral. If wages rise to some
extent as a result of price inflation, this will raise costs which
will raise future prices. The received wisdom in central banks (from
the mid-2000s as well as the 1970s) is that some reduction in demand
is required to stop a wage-price spiral developing.
The likely
level of excess or insufficient demand in 2022 should be crucial in
this respect. If there is already insufficient demand, and lower real
incomes will only make that worse, then central banks have little or
nothing to do. In contrast if the labour market is currently tight
and likely to stay tight the dangers of a wage-price spiral are much
higher. It therefore makes sense to start any assessment by looking
at output levels.
In terms of the
major economies, we did get a V shaped recovery from the pandemic,
but where the V stands for vaccines. As soon as vaccines became
widely available, the economy expanded rapidly, as I showed here.
Vaccines removed the need to lockdown the economy, and gradually gave
consumers confidence to engage in areas of social consumption.
However the recovery
was not equally strong in the major economies. Here is an updated
chart of one I showed in that earlier post, looking at GDP per capita (2019=100) rather than GDP.
The US not only had
a less severe COVID recession than the UK and France, but it has also
had a much stronger recovery than the other three economies. (You can
also see how the last ten years have been a decade of relative
decline for the UK, matched only by France because of Eurozone
austerity around 2013.)
Matching this is a
clear hierarchy in inflation rates. If we look at Core inflation in
each country, the US is the highest at 6.5% for March, while Germany
is at 3.4% for the same month and France 2.5%. However UK core
inflation is surprisingly high, at 5.7%, even though it has had a
similar recovery to France and Germany. One of the reasons is Brexit,
which we discuss below.
It is of course
possible that the pandemic has caused a permanent reduction in the
supply of goods, either through lower technical progress, capital or
labour. I find it difficult to believe that the pandemic has had a
permanent impact on technical progress, or that lower investment
during the pandemic cannot be rectified by high investment later as
part of a sustained recovery. The experience of the UK and elsewhere
before the GFC was that recessions did not lead to a permanent
reduction in productive potential.
The pandemic does
seem to have had, so far at least, a negative impact on labour supply
in the UK and US among older workers, in what has been called the
Great Retirement. There are lots of possible reasons for this,
including less need to work for some as a result of additional
savings over the pandemic. However another potential explanation is
Covid itself, and in particular Long Covid, as this Brookings
study outlines, or the indirect effect of Covid
because other health problems have not been fixed as quickly as they
should. (For the equivalent for the UK, this
briefing note is a good place to start.) France has
avoided similar problems, in part because of early
retirement.
This might suggest
that US growth since 2019 may have exceeded the growth in supply, but
elsewhere it is completely implausible to suggest these problems are
big enough to give you zero growth in potential since 2019. This
suggests the following:
-
In the US,
relatively high inflation and strong growth combined with a
reduction in labour supply could indicate an economy above its
‘constant inflation’ position (i.e. has excess demand). -
France and
Germany, with weaker inflation and projected output per capita in
2022 at around 2019, indicate economies probably below their
constant inflation position, suggesting excess supply in these
economies.
-
In the UK we
have a special case due to Brexit.
Here are a few
thoughts on each in turn.
United States
With high vacancies
and wage growth at
around 5% in 2022Q1, high inflation in the US has
become more broadly based than it once was. An important reason for
this, which is shared by the UK, is a drop in labour supply after the
pandemic. The Federal Reserve Bank of Atlanta has
hourly or weekly earnings at 6% in March.
The IMF’s
projected growth for 2022 implies annual increases in underlying
output since 2019 of around 1,4%, which does not at first sight seem
unreasonable. However if the pandemic has reduced the supply of
labour or some other element of potential in a significant way, this
growth would indicate excess demand. This is the IMF’s view, which
suggests excess output of over 1.5% in 2022. This judgement seems to
be shared by the Federal Reserve, which recently increased interest
rates by 0.5% on top of an earlier 0.25% increase. However, there are
two major risks in the monetary tightening which is currently
underway.
The first is that
this contraction in labour supply may be temporary. The second is
that the economy is heading for a significant downturn or even
recession of its own accord, without the help of policy. As higher
prices squeeze real wages, consumption growth may decline
significantly which will drag down GDP. (The fall
in GDP in the first quarter of 2022 may be erratic, or
it may indicate this is already happening.) If either happens,
raising interest rates rapidly could turn self-correction into a
period of serious insufficient demand.
If neither risk
occurs, I think it is wrong to conclude that Biden’s fiscal
stimulus was ill-judged, for three reasons. The first is that very
little of current high headline inflation would have been avoided if
that stimulus had not occurred. The second is that a long period
where interest rates are close to their lower bound indicates an
inappropriate monetary/fiscal mix, and some correction such that a
fiscal stimulus leads to moderately higher interest rates will allow
monetary policy to more effectively respond to any future downturns.
[1] Third, that stimulus was probably the only politically feasible
way to reduce poverty quickly.
France and
Germany
Whereas the IMF
expects the US to have excess demand, it projects both France and
Germany to have insufficient demand in 2022. It would be quite wrong,
therefore, to argue that ECB interest rates should rise. Indeed, with
interest rates at their lower bound, and higher energy and other
prices likely to cut personal incomes, there is a strong case for a
significant fiscal stimulus to raise GDP.
United Kingdom
Is the UK more like
the US (current excess demand) or France/Germany (current deficient
demand)? The level of core inflation, and the actions of the Bank of
England in raising rates, suggest the UK is more like the US. Both
also have tight labour markets and nominal wage inflation that is
inconsistent with a 2% target. But I would argue that is where the
similarities end.
The first obvious
point is that projected growth in output per head in the UK has been
much weaker from 2019 to 2022 than in the US. As I have already
noted, the UK looks much more like France and Germany in this
respect. A major reason for that is fiscal policy. Instead of sending
a cheque to every person (as in the US), the Chancellor has announced
a freezing of tax thresholds and higher NICs. [2]
So why is UK core
inflation nearly as high as the US, and much higher than in France
and Germany? One important reason is Brexit, which has raised UK
inflation through various routes. We already know that the immediate
sterling depreciation after the referendum result increased inflation
in earlier years. In addition this
study estimated that the Brexit trade agreement has
directly increased UK food prices by 6%. This is because additional
barriers at the border (checks, waiting times, paperwork) are costly.
Importers can switch to non-EU sources, but that will also mean
higher prices. More generally the Brexit trade barriers may lead to
the creation of new, but less efficient, supply chains, pushing up
prices. Finally these trade barriers mean reduced competition,
allowing domestic producers to increase markups.
One additional
possible inflationary consequence of Brexit that has been talked
about a lot is due to labour shortages in low paid jobs because of
the ending of free movement. While those shortages are real enough
(vacancies for low paid jobs have grown much more rapidly), up to the
end of 2021 this does not seem to have led to higher pay growth
according to this
IFS study (see chart 3.2 in particular). As a separate
briefing
note from the IFS points out, there is one sector that
has shown rapid earnings growth recently: finance. (For a good
discussion of the UK labour market, see here.)
If we look at earnings
growth in the first two months of this year, however,
we see quite rapid growth in earnings in the wholesale, retail,
hotels and restaurants sector. [3]
Yet all these
inflationary impulses due to Brexit are temporary, reflecting the
one-off nature of the trade barriers, reduced competition, labour
shortages etc. While the increase in wages in the US is broadly
based, that is not the case in the UK, suggesting a relative wage
effect rather than general inflationary pressure. As a result, I
think there is a serious danger that the MPC are seeing misleading
parallels between the UK and US, whereas in reality the UK’s
situation is much more like France and Germany with a short term
Brexit inflationary twist. If I am right, then monetary tightening
coupled with fiscal tightening and higher prices for energy and food
could
spell recession. [4]
My view on likely
interest rate moves is not shared by the markets, which are expecting
many more rate increases from the MPC. The Bank’s arcane practice
of using these market expectations in their main forecast has
confused a lot of people. If you want an idea of what the
majority of the MPC currently think will happen, it is better to look
at their forecast using current interest rates. That shows inflation
falling to just over 2% by mid-2025, and annual GDP growth of between zero
and just over 1% in every quarter of 2023, 2024 and 2025H1. That is
not exactly an exciting prospect, but it is not a serious recession
either. The problem, as I noted
here, is that forecasts are poor at predicting
recessions.
The MPC may be right
or wrong, but the outcome in either case is pretty dire for the UK
economy. If they are right to raise rates, then the best the UK can
do after the pandemic is return GDP per capita to 2019 levels. That
will mean that the pandemic in the UK, and the policy reaction to it,
has lost at least three
years worth of growth. If the MPC is wrong, raising rates will
cut short a recovery in output and risk a recession which once again
[5] risks policy induced deficient demand choking off long run
supply, making everyone in the UK permanently poorer.
[1] Some might argue
that in an ideal world fiscal policy should always respond to excess
demand or supply, and therefore interest rates can stay very low.
However the US is perhaps the country which has a political system
where this kind of fiscal activism is least likely to occur without
prior fundamental reform.
[2] In judging the
impact of any fiscal stimulus, looking at measures of cyclically
adjusted (or ‘structural’ or ‘underlying’) budget deficits
can be very misleading. To take a clear example, if a country
announces a five year programme of buying fighter planes from another
country, its deficit increases but this provides zero stimulus to the
domestic economy. The Biden stimulus was like helicopter money,
except the rich got nothing. Furlough on the other hand gave people
money in proportion to their salary. A stylised fact is that the
wealthier people are, the less of any government transfer they will
spend, and the more they will save. As a result, giving a fixed
amount to the non-wealthy is much more effective at boosting demand
than a furlough type scheme.
[3] The Bank
of England say “underlying wage growth is projected
to pick up further in the next few months”, so perhaps they are
expecting a delayed reaction to high vacancies.
[4] It is easy to
blame the MPC, but these issues are complex and its remit limits how
much the MPC can ignore a sharp rise in inflation. I certainly do
not think governments are better placed to make these economic
judgements. What I think can be done is change the MPC’s remit to
place more emphasis on output while making the inflation target more
long term, as I suggested here.
[5] I say again
because that has to be part of the story that explains the lack of
recovery after the Global Financial Crisis, although the blame then
lies with fiscal policy (austerity).
