Imagine, for just a moment, you’re an economic policymaker tasked with managing the path of an economy. Now envisage a set of economic conditions that makes your task near-enough impossible. That, unfortunately, is where many real-life policymakers find themselves today. There’s too little growth but there’s also too much inflation. The former typically demands interest rate cuts. Doing so, however, simply threatens more by way of inflation. The latter typically requires interest rate increases. Going down that path, however, may trigger a recession.
For its part the Federal Reserve has already made clear its primary fear. By raising the key US interest rate by a further three-quarters of a per cent last week, the Fed appears determined to return the US economy to “price stability”. As Jerome Powell, the Fed’s Chair, stated following this latest tightening of monetary policy, the Fed is “strongly committed to bringing inflation back down” and “moving expeditiously to do so”. Strong stuff, particularly when there’s evidence that the US economy is shrinking.
Here in the UK, interest rates are heading higher, but the Bank of England seems much more worried about growth than inflation, at least compared with the Fed.
The Bank believes that, with prices rising faster than wages, demand in the UK economy will naturally falter. When it does, inflation will fade from view. Seen this way, there is only so much monetary policy needs to achieve, even if the Bank ratchets things up a bit at its policy meeting later this week.
It’s a comforting thought, perhaps. Yet it may not be right. As inflationary expectations head higher, more and more people in Britain may fear that inflation is no longer just a temporary phenomenon. There’s a danger that, for any given growth rate, inflation will then be permanently higher.
You might regard such issues as being of academic interest alone. After all, over the past three or four decades, inflation has been mostly well-behaved. No longer. The latest confirmation indeed came from the US. Although it is true that the “value” of US national income rose in the second quarter, it is more accurate to say the value of money — cash, bank deposits and so on — fell. To purchase a given volume of national income, more money was required in the second quarter than in the first.
The case in the US, though, for threatening aggressive action is simple. If everyone knows that a further acceleration in inflation will lead to still more painful interest rate increases and, thus, to an even bigger recession, there’s a reasonable chance that price and wage increases might start to moderate sooner rather than later. Once moderation is established, the need to raise interest rates still further will begin to fade. It is the central banker’s equivalent of a conjurer’s trick.
There are, however, three problems with this approach. First, US inflation is now very high indeed. Yet even with the Fed’s latest actions, interest rates are still very low. History suggests they might need to rise further before they temper people’s inflationary fears.
Second, even with a marginally shrinking economy, the US labour market is still very buoyant. People are easily able to jump to a higher-paid job elsewhere, one reason why wage pressures are unlikely to ease anytime soon. As such, even if headline price inflation begins to fall thanks to, say, an energy price reversal, there’s a risk that wage pressures may persist.
Third, what’s true of the US is also increasingly true elsewhere. The UK is a case in point. Headline inflation is vastly higher than it ideally should be, yet although the Bank of England started to raise interest rates much sooner than its American counterpart, it has been for the most part more cautious.
Governor Andrew Bailey and his colleagues argue that much of our inflation is a consequence of events beyond our control, most obviously the impact on gas prices of Russia’s invasion of Ukraine and, more tangentially, the disruption to global supply chains caused by China’s repeated Covid-driven lockdowns.
But if demand does falter yet inflation remains high, there’s a word for this. In the Seventies, people called it stagflation. It was messy. It was painful. And, unfortunately, it appears to be coming back.
