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Central banks should keep their cool on inflation

During the pandemic, US and euro-zone central banks have reformed their monetary policy strategy in a major departure from previous practice. After a decade of below-target inflation and a painfully long time for employment to return to previous peaks, rate-setters pledged to ease inflation temporarily above target as long as sustained monetary stimulus was otherwise warranted.

This should cement central bankers’ nerves in the face of some nasty supply-side surprises. And for a while they kept their cool during the inflationary surge. But they have not kept up the courage of their newfound beliefs. Instead, they were intimidated by criticism to dismiss the possibility that high demand pressures could draw more resources into the economy than previously thought, eventually helping to contain price pressures while sustaining growth.

Central banks now seem determined to restore that monetary version of the toxic machismo that says if it doesn’t hurt, it doesn’t work. Leading policy makers are increasingly explicit about their intention to cut inflation, even at the expense of growth or making people unemployed. The markets have taken their arrows and are bracing for recessions.

Of course, central bankers don’t like that. Their case rests on the idea that there is no better alternative. But if so, they better be absolutely right and unfortunately their argument is weaker than many think.

Initially, the rise in inflation was almost generally attributed to supply shocks. But despite the obvious role played by Vladimir Putin’s attack on Ukraine and the subsequent tightening of gas supplies, mainstream opinion has somehow shifted to blaming excessive demand.

Yet it is only this year that nominal spending has surpassed the pre-pandemic trend in the US; and it still hasn’t done so in the UK or the Eurozone. Even in the US, the total volume of goods and services purchased (as opposed to their market value) is right on the pre-pandemic trend. So it’s not so much a runaway demand as a recovering demand (itself a triumph of crisis policymaking) that is facing higher prices for supply-side reasons.

The obvious answer is that even if demand is near normal levels, supply may not be, either because of the pandemic or because of spikes in energy and commodity prices. But how sure can we be that these are sustainable problems? (There’s little point in triggering a recession to make up for temporary hitches in supply.)

The pandemic could have hurt the economy’s productive capacity by reducing the number of healthy workers. But not in the eurozone, where many countries have record high employment rates. And while the U.S. economy still employs nearly a million fewer people than it did in February 2020, the current boom continues to add jobs at rates more than twice the pre-pandemic average. Job growth also remains strong in continental Europe.

There is little sign of this extinguishing. But central banks could stop it with their determination to curb demand growth. So the question arises: is what our economies need most right now to have fewer people in work? Is it not necessary, even with the lens of inflation, to allow employment and thus supply to grow strongly, which is necessary to sustainably reduce price pressures?

The same goes for the energy crisis. For net energy-importing economies, high oil, gas and power prices make them poorer, so they will have to export more and consume less to meet their energy needs. How is this problem solved by also reducing domestic production, when the contraction policy affects both employment and investment? (As for countries that are not net importers, higher energy prices cause inequality that can only exacerbate monetary tightening.)

The final argument for tightening in a supply-driven recession is to avoid a wage-price spiral. But the rationality of this depends on the risk being more than theoretical. In itself, wage increases are of course welcome – and robust profit margins suggest that labor costs are not pushing prices up. It’s also worth noting that countries with the largest collective bargaining coverage (France, Italy, Scandinavia) have the lowest inflation rates.

None of this should belittle the real suffering caused by the cost of living crisis. But monetary contraction on the eve of a recession will worsen things to no avail. Governments should provide support to those hardest hit by the price hikes. But perhaps – precisely for the sake of monetary and economic stability – central banks should treat inflation with more benign neglect.

martin.sandbu@ft.com

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