Governments and central bankers may have paved way for severe pain in near future
A spectre haunts central bankers and governments—the spectre of inflation. With the post-COVID rebound in economic activity, the last year has seen spikes in consumer prices around the world. In the United States the annualized rate of inflation (CPI) in July reached 5.4 per cent. In Canada, inflation in June was 3.1 per cent. In other countries for June and July, there have been similar reports including many in the European Union and the Asia-Pacific.
Germany, for example, hit nearly 4 per cent in July while India saw inflation in July also at more than 5 per cent. While China apparently only saw a 1 per cent increase in CPI, the increase in producer price indices, as in India, was much higher approaching nearly 9 per cent, fore-shadowing spillover into consumer prices down the road.
We are of course assured by governments and central bankers that all of this is transitory. In other words, this is a temporary inflation in response to economic shocks brought about by the pandemic and inflation rates will revert to recent historical norms of closer to 2 per cent in the not-to-distant future. This would be distinct from continuing or non-transitory inflation where rates remain higher or continue to increase.
Yet, unlike the traditional definition of a recession of two consecutive quarters of negative GDP growth, there’s no convenient back of the envelope definition of what constitutes transitory as opposed to non-transitory inflation. How many quarters of “transitory” inflation should there be before our lords and masters deign it to be somewhat more ingrained and therefore more of a problem?
In many respects, the potential for 1970s-style inflation is much diminished. Globalization created much more elastic supply curves around the world, and for inflation to become permanent and increasing, there also must be expectations of inflation that cause demand shifts that fuel more inflation. As well, unionization rates in many developed countries are much lower than decades ago, making it more difficult for cost-of-living increases to filter into contracts. At the same time, for inflation to continue, there must be validation of that inflation either through monetary or fiscal policy. In this regard, the seeds of validation are in place given the massive expansion in money supply by central banks around the world and the enormous fiscal stimulus applied to deal with the pandemic.
Inflation generally begins with either a demand-side shock or supply-side shock. In the current situation, the economic slump of the pandemic would have been expected to slow inflation and even generate deflation. However, governments around the world—Canada included—have injected an enormous amount of liquidity into the financial system, keeping interest rates at extremely low levels. And this has persisted even as economies have recovered.
At the same time, the trillions of dollars spent worldwide in fiscal expansion via subsidies, income supports and infrastructure projects, whether needed or not, has created another enormous demand-side boost to spending. When this is coupled with the supply-side shocks of COVID that have disrupted supply chains and the unique micro-demand shocks affecting specific goods from lumber to furniture, it’s not surprising that prices are rising and will probably go up in the future. This is not a simple case of demand- or supply-side inflation, it’s both. For macroeconomists and central bankers, this is undiscovered country.
The inflation of the ’70s became ingrained and took several decades to finally extinguish. The tool was not moral suasion or wishful thinking, it was a tightening of monetary policy that raised interest rates in two phases, the early 1980s and the early 1990s. In each case, there were much higher interest rates that ultimately fed back into the economy resulting in a severe economic slowdown that brought price increases to heel and raised unemployment.
If inflation becomes continuing, then eventually interest rates will rise, and given the enormous debt levels that have been acquired, will cause considerable economic pain. In their efforts to spare economic pain now with double-barreled fiscal and monetary stimulus, governments and central bankers are running the risk of much more severe pain down the road.
At minimum, interest rates need to adjust upwards in measured and gradual steps at our leisure rather than later—in a hurry.