Winner of the New Statesman SPERI Prize in Political Economy 2016


Monday, 7 June 2021

How should we think about talk of an impending US inflationary spiral?

 

In 2013 I was presenting at a Bank of England conference. The UK recovery had stalled for three years. I cannot remember the details, but I was probably arguing that the economy desperately needed fiscal stimulus, not more austerity. A very well known academic and ex central banker started talking about inflation and the dangers of expectations becoming 'unhinged'. In my response I came quite close to losing my cool.


I wrote this post afterwards, which attempted to analyse why I had got so angry at that word ‘unhinged’. It is, after all, used a lot by central bankers and some economists. But its use makes no sense in today’s world. Here is a passage from that post:

“It is as if inflation expectations can be in one of two states: either low variance with mean reversion to the inflation target (or something close to it), or as highly volatile and could go anywhere. In this second imagined state, as expectations of inflation drive actual inflation, we could have ‘inflation bubbles’, which would become very costly for the central bank to prick. As we really do not want to go to that second state, we have to do everything we can to stay in the first state.

It is this view of the world that I find very difficult to believe - in fact I find it absurd.”

I still find it absurd. We cannot at the same time talk about how long term inflation expectations have become fairly anchored to the inflation targets as a result of central banks controlling interest rates to hit that target, and in the next breath talk about expectations becoming unhinged while the same central banker with the same or very similar inflation target is in place. That makes no sense, unless the aim is to permanently run the economy with a weak labour market as Kalecki suggested capitalism would.


All the evidence, direct or indirect, points to the story about fairly anchored long term inflation expectations due to inflation targets and independent central banks being correct. Most macroeconomists say they believe this story. That is why they prefer independent central banks (controlling inflation with inflation targets) setting interest rates instead of national governments controlling inflation by setting interest rates or fiscal policy. In that context, and when short term interest rates are at their lower bound, it seems bizarre in the extreme to start worrying about inflation expectations becoming unhinged.


The whole point about flexible inflation targets is that positive inflation shocks due to commodity prices increases, or temporary shortages (labour or goods), no longer kick off an inflationary spiral. If what was temporary becomes permanent, the central bank can raise rates to cure the problem. The clearest example of that was the oil price boom that started in 2004, which came nowhere near repeating the experience of the 1970s.


The whole point of the new state contingent policy regime that many macroeconomists now favour is that fiscal policy looks after recessions and interest rates stop inflationary spirals. If fiscal stimulus does not lead to inflationary pressure that requires interest rates to rise above their lower bound it is not a big enough stimulus.


The failure of the last decade in the US, UK and Eurozone has been the absence of that stimulus (and instead austerity), and unconventional monetary policy being insufficient to cope with severe recession. The failure is manifest in a largely unexplained shift down in the path of ‘trend’ output. As many of us explained before this happened, being conservative about policy risks a long term deterioration in output and prosperity. The upside risk was trivial in comparison because raising interest rates are very good at keeping inflation steady in the medium to long term.


This is the central argument about why it’s best to overshoot on fiscal stimulus rather than do exactly what you think you need to do to hit the level of output that stabilises inflation. It is the argument of asymmetric risks. If you are conservative or do exactly what you think you need to do, the risk that you get things wrong because the stimulus turns out to be insufficient (because your calculations were wrong or unexpected things happened) is much greater than the risk that you overshoot. If you overshoot you quickly get higher interest rates and a temporary blip in inflation. If you undershoot it will take you some time to realise what has happened, and you will have lost real resources for everyone in the economy forever.


As I noted here, the Eurozone and the UK seem to be intent on making the same mistake again, approaching a conservative view of the natural rate gradually from below. Only in the US do policymakers understand the mistakes they made before. After a failed coup against democracy and the opposition party in thrall to the coup maker that is hardly surprising.


Does the change in US monetary policy to a form of average inflation targeting change the logic of going bigger than you think you need to? In fact the opposite is true. It means that some excess inflation will be tolerated for a time, to make up for previous persistent undershooting of the target. That shouldn’t mean that long term inflation expectations rise above target, as long as the central bank is clear what it’s doing. It remains the case that in time interest rate rises will bring inflation down if necessary. As long as US monetary policy makers, who have high levels of credibility, make it clear that excess inflation will only be tolerated until a clearly defined state is achieved, they prevent long term inflation expectations rising.


When you add this to the argument of asymmetric risk, any fiscal stimulus needs to be targeting not just the higher inflation the Fed will tolerate, but higher than that. The Fed should have to raise interest rates in response, and if they didn’t need to you have a fiscal policy failure. (That failure is an all too likely outcome in the Eurozone and the UK.)


So those who say that Biden’s plans would raise inflation should be met with ‘I would hope so’. The same reply is appropriate if we replace ‘inflation’ with ‘interest rates’. Of course it is still possible that Biden’s plans (even after they are watered down?) are likely to raise inflation by far too much, requiring far too great an increase in interest rates, even allowing for the asymmetric risk outcomes argument. That I think is the view of, most notably, Summers and Blanchard.


I’m not going to add to the many different assessments of exactly what the first Biden stimulus will do. Instead I will point to why I think the Biden critics are wrong, which again goes back to the theory that macroeconomists teach today. The people who really need the stimulus cheques will spend a lot or all of it, but no one is arguing against supporting these people. The argument is that the cheques are also going to people who don't need them, and have saved a lot because of COVID. But being savers, these are people who will save most or all of the stimulus cheques (see Florin Bilbiie, Gauti Eggertsson and Giorgio Primiceri here). As a result, Summers’ assumption on the demand impact of the stimulus cheques seems too high. I have consistently argued that the end of pandemic will see an increase in pent-up consumption, but that is a very temporary affair.


The US is streets ahead in macroeconomic policy terms than both the Eurozone and the UK. Both the latter have not changed their monetary policy goal and still obsess about deficits. If the forecasts prove correct the US will come out of the COVID recession with no long term scarring, while across the Atlantic we will not. No doubt lots of what Krugman calls Very Serious People in the UK and EZ will find reasons for why that was inevitable and had nothing to do with an inadequate stimulus. The reality will be that the US learnt from past mistakes, but the same leaders who presided over the austerity disaster after the Global Financial Crisis haven’t fully understood what they did wrong.







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