Inflation’s surge following excessive stimulus and an energy crisis makes the way ahead hazardous
By Andrew Shouler
Stagflation is upon us, inflation leading towards economic stagnation. Western economies are in danger of tipping into recession, under the weight of inflation itself, besides some meagre policy tightening in response to its threat. The reverie that it would not happen has been shattered.
Some of that relates to the energy crisis. The prices of pretty much everything have jumped, given the basic component of transportation in supply chains. It’s an unavoidable cost where energy dependency has been created, whether by the green agenda or susceptibility to geopolitical events.
But inflation is not a price jump as such, but a sustained trend, which can only endure because the money is supplied to finance it. Otherwise, the loss of purchasing power to businesses and households from the cost shock would translate initially into economic retrenchment.
Because governments don’t like that prospect, they spend more to try to offset it. As demonstrated by the oil shock era of the 1970s, it works only for a while.
Today households are tightening their belts, particularly as regards non-essential items. They are not hastening those purchases, as economists like to assume, but delaying them, as everybody else naturally understands.
The world’s central banks have had to admit that inflation is not transitory as previously claimed. But it is the underlying issue that is fundamentally troublesome.
Firstly, they haven’t recognised causation. They talk about containing inflation expectations (as European Central Bank chief Lagarde did earlier this month), as if dealing with an ephemeral phenomenon, rather than preventing excessive money creation. Moreover, they think they can fine-tune the economy by managing demand, as if growth and inflation are necessarily tied, and it’s just a matter of setting the dial. Both sensible reasoning and economic history advise that this axiom is untrue.
In fact, growth and prosperity that are sustainable (in the original sense of the word) stem quintessentially from the quality of supply rather than quantity of demand. All the authorities have to do is (a) encourage the supply side of the economy to be productive, in physical and non-physical infrastructure, education and skills, tax policy and cultivating entrepreneurship, and better regulation, and (b) match it on the demand side, by how much money is circulating, through monetary and fiscal settings – with luck, not too little and not too much.
Controlling inflation linearly alongside growth on a sliding scale is a false precept, since they are sourced differently, so cannot be managed together. Only in the shorter term do they align; in the longer term they perform separately. The devastating consequence of that reality is that central banks trying to manage both are inherently liable to fail. In fact, managing the real economy (of goods and services) is not actually their business at all, but a matter of culture, politics and government policy.
The trouble ultimately is that politicians tend instinctively to like spending more money — taxed, borrowed or printed. Of course, they justify it by invoking economic development and creating jobs. Meanwhile, taxing Peter to pay for both Paul and Paula works mathematically quite well in electoral terms. Projects as memorials to the endeavours of political figures are also built with public money. We all know it.
Sometimes those things are affordable, even necessary. At other times dispensing yet more money is precisely the wrong thing to do. It gets wasted and does damage. We all know that too. While governments frequently resort to budget deficits anyway, they and central banks have been throwing money around like there’s no tomorrow, not just through the Covid experience, but prior to the global financial crisis over a decade ago.
But whereas tomorrow in the dreamy political world may never arrive, in the real world practically speaking it soon enough becomes today.
Secondly, the deficiency of the official framework is proving chronic. US Federal Reserve chair Powell talks now of adjusting interest rates to neutral, where growth and inflation together find an equilibrium — which yet again misses the point. Bank of England governor Bailey has spoken recently of treading a fine line. But they are not walking a tightrope. They resolutely walked further and further into a dark jungle, and into an elephant trap.
Thirdly, the resulting situation has thereby become acute. Higher interest rates would indeed inflict harm in the short term, with knock-ons throughout the economy. That makes it difficult for policymakers, even if (debatably) better over the longer term. The socio-political ructions might be intolerable. Lower interest rates, meanwhile, would only dig the hole deeper. We are stuck, with genuinely no easy escape route.
Other issues have been identified in various commentaries on this situation. Unfortunately, many still show related confusion.
Some even argue monetary policy should not be tightened, as if permanent inflation is not itself harmful, or at least not like temporary unemployment. That relates to, and compounds, the original sin, as if two wrongs make a right. They tend to be the same lobbyists arguing for extra stimulus all along, wilfully lopsided in their approach.
A similar argument, underlined lately by the IMF, concerns inequality. It says the rich have gained disproportionately from low interest rates boosting real estate and financial investments, but it is the poor who will suffer disproportionately from higher rates, perhaps through their indebtedness. True enough, but that ignores the ongoing cost of inflation to the poor especially, hit either way.
Indeed it is odd that self-styled progressives, favouring heavier redistribution from rich to poor, should not have objected to prolonged low interest rates obviously producing very regressive results. The reason surely is that low rates favour spenders over savers, and the state over households.
In Europe there is another rationale. The ECB is determined to keep interest rates artificially low to try to keep monetary union together, seeking to compress the different sovereign bond yields of member states. Otherwise, countries with better creditworthiness would have much lower borrowing costs, stiffening the structural challenge to the whole system. The euro is suffering from that inertia, adding to inflation pressure. As it is, some countries are perpetual creditors and others perpetual debtors in any case, and increasingly so.
Another view is to blame the financial markets themselves, particularly in the US, and say it is time for policy belatedly to serve the real economy instead.
Yet it is the Fed itself that has quoted the wealth effect as the theoretical basis for its policy — namely that income filters through society to everyone else. That ‘trickle-down’ idea was rejected even by a Republican president (Bush Sr) in the 1980s, and is a very strange platform for policy today under a Democrat administration. Except of course for the reason mentioned.
Now, ironically, financial markets perceive the Fed’s unmistakable loss of credibility, and what is happening to the economy, and are inclined to retreat. They have ridden each wave of excess money, knowing it would be forthcoming to promote their upside and limit their downside. Their investments have effectively been underwritten. Yet they know that policymakers are stymied now. The energy shock only amplifies the dilemma.
So much for the past; what of the future?
The bond market is now nervous about both easy and tighter policy options — the former would suggest inflation is not being taken seriously, whereas the latter might crunch the economy. Stock markets are spooked too, partly by association, primed for volatility, unsure whether steeper inflation or recession is next.
Investors and savers will either have to be nimble or mainly defensive, hedging their bets to limit the cost of whatever policy decisions and market reactions transpire. The outlook is plainly tricky.
It is a fair assumption that central banks will lean towards allowing inflation, keep interest rates low, and play for time, given that the cost shock of the energy price surge will gradually seep out of the annual data automatically. They will want to protect borrowers, including governments, and they will want to some extent to keep the markets sweet.
The trouble is that the economy will suffer either way – because, it must be emphasized, inflation actually hurts growth.
For governments, it is surely time to review policymaking. Yet, while the dismal record of central banks has prompted calls for changes in their mandate, actually the instructions they have followed sowed the confusion. G3 central banks all officially have to balance inflation with growth concerns, meaning they are burdened with the same misreading from the outset.
What is vitally needed is an acknowledgement of how we got here, and a thorough review of what to do about that. Will the institutionalised policy error be corrected? The chances are that we will be told it is the market system which isn’t working, taxes must rise, inflation must be tolerated, and the government must intervene further, to take care of everything.
That would be the worst-case scenario, in economics jargon. It would be an utter travesty. But who’s to say it won’t happen?
Andrew Shouler is a freelance writer and former banking economist
