Complacency led policymakers to misdiagnose inflation
A year ago, inflation seemed under control. Published annual consumer price increases were 2 percent in the eurozone and 2.1 percent for the UK in May 2021. The 5 percent figure for the US was higher than usual, but the Federal Reserve rejected worriessaying price rises reflected “temporary factors” with chairman Jay Powell to mark wood and used car prices that were temporarily high and aviation and hotel costs that were just returning to normal.
What has happened since has taken all the major central banks of the advanced economy by surprise. The latest published inflation figures are 8.6 percent in the US, 8.1 percent in the eurozone and 9.1 percent in the UK. Instead of always blaming something beyond their control, central bankers are now taking action.
So we have to use this moment to take stock. What thinking mistakes have been made in the past year? And what does this mean for policy and the economic outlook?
Fundamentally, we have rediscovered that limited resources are real and matter. With unemployment in North America and Europe at multi-decade lows, there was less room for households, governments or businesses than after the global financial crisis to increase spending without creating significant inflationary pressures. Of course, sometimes resource constraints are also caused by supply chain bottlenecks, but both represent demand exceeding supply and both are inflationary.
Rather than focusing closely on the restrictions, politicians and central bankers placed too much emphasis on data from the 2008-09 global financial crisis, which showed that changes in unemployment had little impact on wages or prices. Inflation had been low and stable both when unemployment was high and when it fell. Policymakers have frequently misdiagnosed this ‘flat Phillips curve’, leading to complacency. The thinking was that inflation was dead and there were few risks in running an economy under pressure. We now know that this was dangerously wrong.
Central bankers bear a special responsibility in this messy story. Over the past two decades, they’ve convinced themselves that the public thought they were such great price checkers that they could sit back and relax. No company would try to raise prices and no employee would seek inflation-reducing wage increases because they knew it would be beaten by the central bank.
They believed their credibility was rock solid, so low and stable inflation was a self-fulfilling prophecy. That theory has failed and they are now fighting to regain public trust. Unsurprisingly, for example, net satisfaction with the Bank of England’s management of inflation has fallen to its all-time low.
The result of these analytical flaws and complacency has been the recent rapid rises in interest rates, designed to demonstrate that central banks are serious about beating inflation. But this only brings us to the next problem. All the major models used to control inflation are calibrated during a period of price stability and tell us very little about how far monetary policy should be tightened if you are out of control.
Some of the rise in inflation is still temporary, but a lot will have to be squeezed out of the economies without anyone knowing exactly how much pressure to apply. This means that the dangers of over-tightening are just as great as doing too little, too late.
In such a difficult world, no one should rule out recessions in the coming year. The Fed is probably right about raising interest rates hard, but the truth is, we really don’t know.
Further monetary policy errors are highly likely and we should expect policy reversals as central banks try to find the right answer to a problem they thought could not happen.