- Inflation continues to accelerate in most advanced economies.
- This is true for both monthly and annual data, both headline and core.
- So why are central banks so sanguine about inflation developments?
Recent months have, on the whole, seen inflation continue to accelerate in most of the large advanced economies. As pointed out in last month’s Comment, the 12-month rate is currently not particularly important. But the faster price rises are also visible in monthly data. Moreover, not only headline inflation, but also core and producer prices are rising faster. In addition, both financial markets and survey data (such as the EU business and consumer confidence survey, or the US NAPM surveys) show increasing inflation worries. Yet central banks seem curiously unconcerned, maintaining an attitude of “move along, nothing to see”. Why?
There are a number of possible explanations. One is that central bankers are absolutely right. The higher inflation is a temporary phenomenon. It will pass, possibly by the end of the year and it won’t be very high anyway. That is possible, although as outlined in previous Comments over the past year, I disagree.
A second possible explanation is that central bankers simply don’t understand what is going on. If true, that would be deeply worrying. In fact, almost any other explanation would certainly be preferable than the thought that world monetary policy is run by people unsuited to their positions. Yet this view cannot simply be discounted. For instance, in a recent interview with OMFIF (the Official Monetary and Financial Institutions Forum), Philip Lane, the ECB’s Chief Economist, opines, when asked about the danger of higher inflation, ‘I really don’t see that as a likely outcome. A precondition for persistent inflation is a strong labour market. Changes in commodity prices or the pricing power of companies are not enough in their own right. We expect the labour market to take longer than the economy to recover from the pandemic.’
This shows a clear failure to understanding the difference between cost-push inflation, driven by higher input prices (including wages and salaries) and demand-pull inflation, caused by rising demand. (That is not an unusual failure. While I was at Lombard Street Research, one of the chief economists persisted in stating that inflation cannot take off unless wages do; the rejoinder that this meant that real wages could never fall, was left unanswered.) It also assumes that the labour market post-pandemic is (broadly speaking) identical to what it was pre-pandemic, and that the same skills are in demand, meaning there can be no labour market bottlenecks. That may be true, but it isn’t necessarily true.
The fact that most central bankers neither understand, nor ascribe much, if any, importance to broad money developments, unfortunately strengthens the fear that this explanation may have some basis in fact.
There is a third possible explanation. That is that central bankers (and governments) are aware of inflation trends but are terrified of doing anything that might abort the post-pandemic recovery. They are therefore unwilling to act, and hope that something will happen that will make it unnecessary for them to do anything. This might be termed the ‘Mr Micawber gambit’, after the character in David Copperfield who always assumed the “something will turn up”. (It did, as it happens, but David Copperfield is a work of fiction.)
A fourth option is that central bankers (again, and governments) are perfectly happy with current inflation developments. For central banks, who in most cases have spent years attempting – and failing – to reach their inflation targets, success, as it were, is finally in sight. For governments, who have vastly increased their borrowing to deal with the COVID pandemic, higher inflation will erode the real value of the debt, a debt which some day will have to be rolled over.
Admittedly, the most recent FOMC Minutes state that the “Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals.” But this is followed by the phrase “The Committee’s assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”
In other words, inflation may well rise, but we won’t necessarily do anything about it. This view was well articulated by Governor Christopher Walker in a speech on 13th May, when he said “Our willingness to aim for above-target inflation also means we will not overreact to temporary overshoots of inflation—we need to see inflation overshoot our target for some time before we will react.
An outcomes-based policy stance means that we must see inflation before we adjust policy—we will not adjust based on forecasts of unacceptably high inflation as we did in the past. Call this the “Doubting Thomas” approach to monetary policy—we will believe it when we see it.”
Similarly Raphael Bostic, President of the Federal Reserve Bank of Atlanta and rumoured to be a likely next Chair of the Board of Governors if Mr Powell is not reappointed, has been clear that a move to ward off higher inflation is not on the cards.
Other central banks are perhaps less outspoken than the Fed or the ECB but are clearly also dismissing inflation risks. So what all this boils down to is this: nobody is going to do anything about higher inflation, at least not for some time. And that will only make it more difficult and painful to bring it down to acceptable levels again.
 Governor Christopher J Walker, 13 May 2021At The Global Interdependence Center’s 39th Annual Monetary and Trade Conference, The LeBow College of Business, Drexel University, Philadelphia, Pennsylvania (via webcast)
 Interviewed for Axios, 23 May, 2021.