Inflation panic-mongers should not declare victory

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Those who have warned that current macroeconomic policies risk permanently higher inflation were tempted to take a victory lap this week. Both the US and the UK published very high inflation numbers: in just one month Britain’s consumer prices index jumped 1.1 per cent, the American CPI by 0.9 per cent and the eurozone harmonised index of consumer prices by 0.7 per cent (the last two both seasonally adjusted). If such price changes were sustained over a year, we would be seeing annualised inflation above 10 per cent.

Cue Lawrence Summers calling on “team transitory” to “stand down”, Martin Wolf channelling the 1970s and my Swamp Notes colleagues agreeing that “Summers was right”. The implication of these views is that the US Federal Reserve should rein in its monetary stimulus, a policy conclusion comprehensively set out by Jason Furman in a recent lecture.

These are sharp commentators who are well aware of the uncertainty of their judgments. But in the broader, lazier public debate, one can feel an emerging consensus that calling this level of inflation “transitory” has now become a bit ridiculous. The implication is that those who want macroeconomic policy to keep stimulating the economy are guilty of a bad mistake. Continued demand stimulus risks permanently higher inflation or a recession caused by having to raise interest rates much more drastically after leaving it too late.

What can team transitory, of which I am a proud member, reply? The honest thing to do is to revisit what we have said in the past, to examine whether current inflation rises prove us wrong. In my case, my most relevant contribution was in April 2020. I wrote then that we should expect a bounce in inflation and that this would be a good thing:

“We should not be overly worried by this repressed inflation. To the extent reduced production catches up with sustained demand later on, the inflationary pressures will be eliminated — and it is precisely by sustaining nominal incomes that we stand the best chance of maintaining productive capacity through the crisis. Indeed, we should even hope that when pent-up demand is released from its effective rationing, the demand pressure encourages production above normal capacity, as business and people may be willing to put in extra effort to make up for lost time.

Seen in this light, if standard inflation metrics were to accelerate, we should count it as a triumph. It would mean we were not letting demand fall below the economy’s amputated supply capacity; in other words, that we were maximising the chance of a quick recovery once the crisis passes. Conversely, we should be worried if inflation is too low because it would mean we had let demand fall even further than supply.”

It may be too soon to claim my triumph, but I certainly do not feel embarrassed by the latest inflation numbers. Nor am I embarrassed by another relevant piece, in which I pointed out that, as of two months ago, inflation was actually falling on both sides of the Atlantic. That remains correct — the October rises follow months of slowing inflation. I wrote then that “inflation could still become unmoored”. But the fact that slowing inflation then did not prevent a rise today should make us appreciate that a one-month increase need not mean inflation could not slow again soon.

The reason for thinking it might is what I described in May as the “ketchup-bottle economy”. Many of the obvious causes for the current high inflation — extraordinary fiscal stimulus and bottlenecks in manufacturing supply chains — are very likely to go into reverse. This has not changed.

Quite the contrary; the ketchup-bottle argument is strengthened if we note that both bottlenecks and inflation are predominantly taking place in goods production, not services production. (The UK is a bit different, probably because of the trade frictions it decided to place upon itself by leaving the EU.) A new, short article in the Bank for International Settlements Bulletin underlines this point (also read the excellent Twitter thread by BIS head of research Hyun Song Shin). It points out that the pandemic shifted the composition of demand from services to goods, and that goods production is more prone to bottlenecks and the “bullwhip” effect, where producers hoard stock everywhere in the supply chain to avoid shortages. But by the same token, if demand shifts back to services, the opposite mechanisms kick in:

“Some price trends could even go into reverse as bottlenecks and precautionary hoarding behaviour wane. The mechanical effect on CPI could well turn disinflationary during this second phase.”

Take a look at the magnitudes of this effect in the US. Here is the evolution of personal consumptions expenditure on goods and services.

Chart showing US personal consumption expenditures

Note two things about this chart. People have been able to keep consumption up — while the chart shows nominal consumption spending, inflation-adjusted personal consumption expenditures are also up by 3.5 per cent since the start of the pandemic. That, by itself, is a policy victory to celebrate in the worst economic disruption in a century. But, second, the shift in consumption towards goods is enormous. The services share of personal consumption expenditures has fallen from 69 to 65 per cent since February 2020. The growth in nominal demand for goods, of about 22 per cent in that period, is much greater than the boost fiscal stimulus gave to the economy as a whole.

It is no surprise, then, that prices soar in the goods sector. By extension, inflation is, to a large extent, a product of the shift in demand composition rather than overall demand quantity. Look at the chart below and write to me if you can spot any acceleration in services prices. The entire increase in US inflation is down to goods prices.

Line chart of US consumer price index by sector, Feb 2020=100 showing The service price inflation that wasn't

The single most important question for the inflation debate, then, should be whether demand patterns are going to shift back towards services. There are signs this is beginning to happen: spending on durable goods has fallen by 8 per cent since April.

What about policy? Those warning about inflation think holding off on monetary tightening would be a policy mistake. In the spirit of holding ourselves to account, let me share what I wrote to a colleague taking the other side in the inflation debate:

“As for me, I’d be happy to admit I was wrong in the following circumstances: a) by early 2023, inflation has been sustainably above 5%; b) the Fed has significantly tightened policy in 2022; c) employment has stagnated and even fallen, with little sign of inflation abating.” That is to say, inflation does not go away by itself and the Fed causes damage by acting too late.

The inflation worriers want the Fed to avoid this by tightening pre-emptively now. But let us be clear about what this means. Monetary policy reduces inflationary pressures by reducing the amount of activity in the economy. Hawkish calls amount to recommending that the US economy — still below its pre-pandemic trend and with millions fewer people in work — should have less consumption or investment (or both) than people enjoy at present.

To me, that looks like a much worse mistake. It ignores the very likely possibility of ketchup-bottle dynamics. It fails to admit that less consumption and investment means less economic wellbeing. Above all, it seems blind to the fact that high demand is having its desired effect to boost supply. Despite the talk of shortages, people are actually succeeding in consuming significantly more goods than they would have on pre-pandemic trends. The BIS points out that semiconductor exports from east Asia are greater than in 2019. In short, capitalist globalisation is working!

Supply is expanding because the demand is there. If producers expect demand to remain hot, they will invest in greater capacity still. If, in contrast, they are taught — again — that as soon as demand outstrips supply, expert policymakers will cut demand back, the incentive to grow disappears. That is the mistake we have been making for the past 30 years. It would be a tragedy to return to it just when learn we can in fact do better.

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