The great inflation debate


By Dylan Barry, GCPPP staff, July 23rd, 2021

Notable hikes in consumer price inflation in the United States and elsewhere in recent months—a nearly forgotten spectre in the developed world—have rightly received a lot of attention. For the time being, central banks, led by the Federal Reserve, are describing these rises as temporary, as we recently explained (“This inflationary moment”). But what if the rises go on? Should the Fed and other central banks clamp down on inflation if it looks like persistently exceeding their 2% targets, even at the risk of bringing post-pandemic economic recoveries to an early halt? More and more economists seem to think central banks should give themselves, and their economies, a bit more breathing space. But it is controversial, not least among central bankers themselves.

This ANALYSIS looks at the debate over this crucial policy issue at this stage of the pandemic, by going back to basics – the economic costs and benefits of inflation – and by looking at the empirical evidence and the difficult choices faced by central bankers.

Why a debate?

Following past experience of rapid inflation during the 1970s and 1980s, and of the drastic steps Paul Volcker at the Fed took in order to halt it, you might think the issue was settled. But as with all economics, it isn’t that simple. The debate is not about whether to let inflation rip. It is more about how high a price to pay to keep measured inflation as low as 2%, or whether a slightly higher target – say 3-4% — might be beneficial.

Writing in the Financial Times on July 16th the former chief economist at the IMF, Kenneth Rogoff, a highly esteemed Harvard professor, made just this argument.

He wrote that:

There are real risks. But maybe after a decade of below-target inflation, a few years of it being mildly above target, say 3 per cent, might be positively a good thing.

And that:

In 2008, as the financial crisis unfolded, I argued emphatically that central banks should relax their 2 per cent inflation targets and aim temporarily for 4 to 6 per cent inflation for a few years. Had they moved quickly and adopted effective negative interest rate policies, I believe that would have been possible. Higher inflation for a few years would have helped stimulate demand and taken the edge off many countries’ unsustainable debt burdens.

Reminding readers that another IMF chief economist, Olivier Blanchard, had also argued for raising inflation targets to 4%, he went on:

But even with debt problems contained, there are still benefits from temporarily higher inflation. The most important is that the Fed needs to allow above-target inflation occasionally — if it is serious when it says it targets 2 per cent as an average. Many had begun to wonder if that was even possible. After the inflation drought of the past decade, a mild downpour is welcome. Making the Fed’s target inflation more credible should help shift up the term structure of interest rates and give the Fed more room to cut them in future.

Back to basics

To follow the debate, it is worth reminding oneself of two basic issues – what inflation is and how it is measured – and then of how it might hurt or harm an economy.

Simply put, inflation is the erosion in the purchasing power of money over time, resulting from a rise in the average price of goods and services in a given economy. This can happen because a rise in particular product prices feed into a generalised price rise (as with energy prices); because wages rise, especially as workers’ bargaining power increases with labour scarcity; or because the money supply expands rapidly, leading more demand to chase an inflexible supply of goods and services. Or all of the above, interacting in an inflationary spiral, which is what happened in the 1970s.

Central banks’ first problem is that inflation is hard to measure accurately and precisely, as consumer preferences change and technology alters the quality and characteristics of many products. The standard way is to choose a “representative” basket of goods and services and monitor changes in that basket’s prices, with the relevant statistical authority continuously revising the basket to keep up with reality. Naturally, this leads to disputes as to how “representative” the basket is, as to whether the authority is revising the basket appropriately, and as to whether different baskets may be more appropriate for particular purposes. This is why central banks don’t target simply “price stability”, ie zero inflation, because they wouldn’t actually be able to measure it that finely.

On the face of it, inflation might not be thought to matter, if everyone in a country was subject to it equally and if it were reasonably predictable. Reality, however, is somewhat different. Start with the costs:

  • Inflation hurts savers by eroding the value of their nest-eggs, unless the return on a fund or bank deposit can be “index-linked”, ie adjusted according to price changes.
  • It hurts anyone on fixed incomes, such as pensions, again unless those incomes are regularly adjusted in line with the consumer price index, but that in turn means that the fund paying the pension (whether private or public) has to pay more in nominal terms thanks to inflation.
  • The more uncertainty there is over future inflation, the higher the risk premium that lenders demand in order to be willing to fork over their cash. This can mean that real – ie, inflation-adjusted – interest rates will also increase. This also deters business investment, since more uncertainty about prices and higher capital costs makes business planning harder.
  • Some economists argue that the most significant cost of inflation is more esoteric: that higher rates of inflation increase price dispersion. This is a measure of the variability in the prices of specific commodities, eg the difference in the prices of cans of Coca Cola between all the stores in a given city. Such price dispersion makes markets less efficient at allocating resources. The resulting economy-wide losses can be massive.

There are nevertheless some perceived benefits that economists often cite:

  • In some circumstances, inflation may reduce income inequality within an economy, to the extent that tight labour markets can produce successful pressure for higher real wages. “Taking away the punch bowl”, as central bankers have described their role as anti-inflation party-poopers, therefore risks also denying lower-paid workers their moment of greatest bargaining power.
  • Debtors of all kinds may stand to benefit, if inflation erodes the value of what they owe by more than any erosion caused to their income and by more than any resultant rise in the costs of servicing that debt.
  • Sovereign debtors might especially relish the temptation to allow some inflation to help reduce the value of public debts. The postwar period is the most-cited example: in 1946, in the aftermath of World War II, the United States’ debt-to-GDP rose to 108.6%. But within the decade 1946 to 1955, higher inflation—peaking at 14.4% in 1947, but averaging 4.2%— in combination with rapid economic growth reduced that figure by almost half, to closer to 55% of GDP.

However, that imagined inflation-enthusiasm among sovereign debtors must come with some caveats. Inflation will help public debtors only if the cost of servicing their debt does not also rise to compensate the lender, which is what tends to happen for long-term borrowings made on variable interest rates. As market expectations of future inflation rise, bond prices fall and required yields rise, raising long-term borrowing costs and potentially slowing economic growth or even causing a recession. Every time part of the public debt needs to be refinanced, inflation can mean that debt-service costs climb. Moreover, if sovereign debts are owed in a foreign currency, any fall in a country’s exchange rate stands to raise the value of debts in domestic currency by more than the possible inflation erosion.

The category of potential beneficiaries must therefore be narrowed: sovereign debtors fortunate enough to borrow in their own currencies, those fortunate enough not to need to issue much new debt to refinance their existing debt stock, and those whose populations are willing to accept erosion of their own purchasing power and savings to allow their government to inflate away its debts.

In sum: inflation is hard to measure; small amounts of inflation at a stable rate might not do much harm as much of the damage can be compensated for, and would allow economic adjustments to take place without undue interruption; but unstable, unpredictable, higher rates of inflation can cause a great deal of damage. The widespread view that inflation helps debtors, and so might be favoured by governments owing huge sovereign debts – as now, post-pandemic – misses the fact that bond markets demand compensation for high inflation, if they know it is coming. Only unanticipated inflation really offers a “get-out-of-debt-free” card to most governments, and the problem with inflation in modern times is that it does not stay unanticipated for long. Hence Professor Rogoff’s argument that inflation should just be “slightly higher” and only for “a few years”.

The role of central banks

The principal goals, and challenges, facing central banks follow directly from this: being hard to measure, inflation is also impossible to fine-tune; keeping inflation stable is considered more important than maintaining a particular level of inflation; and the nightmare scenario is unstable, even accelerating price inflation.

The central banker’s chief, and potent, weapon to control inflation is a blunt one, the equivalent of economic chemotherapy: administering poison to the patient to save their life. The ‘poison’ is higher average interest rates, achieved by increasing the rate of interest the central bank charges to commercial banks on short-term loans or by using open market operations, like selling off some of the government bonds on a central bank’s balance sheet so as to reduce the available supply of money. Higher interest rates make borrowing costlier for everyone, reducing investment, depressing activity, lowering aggregate demand and applying downward pressure on prices as people are forced to tighten their belts. The cost of having to impose that tool drastically is high: hence the desire to keep inflation stable so as to avoid having to use it.

Central banks have, in recent years, moved between mechanistic approaches that seek to be predictable; and approaches that through well-communicated targeting seek to keep expectations of inflation well anchored. The main mechanistic approach has been the “Taylor Rule,” named for the economist John B. Taylor of Stanford University, under which when the inflation rate rises above its target by a percentage point, ceteris paribus, the monetary authority has to up interest rates by at least a percentage point to bring it back down. Led by the Federal Reserve, most central banks have switched to the broader approach, seeking through credibility and communication to keep expectations stable.

The question now is how does this apply to 2021 conditions? Those conditions include highly disrupted economies; high sovereign debts; spikes in inflation that currently look dominated by temporary factors; and central bank balance sheets that, after more than a decade of quantitative easing, are huge and are themselves acting to distort economic activity in a myriad ways.

Empirical evidence

In the last two decades, a growing body of literature looking at the costs of inflation in real-world economies has begun to question how strict policy really needs to be.

In a paper published in the journal Annals of Economics and Finance, Robert Barro from Harvard University analysed data from close to 120 countries, recorded between 1960 and 1990 (a period that includes the Great Inflation of the 1970s) to estimate the costs of inflation to real-world economies. The data suggest that a rise in the long-term average rate of price inflation by 10 percentage points—from 1% to 11%, for example—is correlated with a reduction in the growth of real per capita GDP in an economy by 0.2-0.3 percentage points per year, or the equivalent of a 4-7% reduction in real GDP over thirty years.

Barro himself described such an impact on living standards as “substantial”, one that is “more than enough to justify a strong interest in price stability”. Nevertheless, the argument for a more lenient approach is based on the fact that this real world impact is much less than what is included in the standard “New Keynesian” models favoured by central banks. Those hold that a hypothetical rise in inflation from 0% to 12% can be expected to depress output in an economy by up to 10%—effective immediately.

The real-world evidence also suggests that the costs of inflation are not only milder than economic theory predicts but are also non-linear. Most economies appear to have a specific threshold level of inflation, ie one below which inflation carries little to no cost—and reducing it further brings no real benefits. Above it, costs begin to kick in.

In industrialised economies, estimates of inflation thresholds tend to settle in the 1-3% range. That is consistent with the 1-2% inflation targets pursued by central banks in such countries, but might allow a little more laxity in today’s unusual conditions. For low-to-middle-income economies, however, inflation thresholds appear to be much higher—11-12% by one study’s estimate, and 15-18% in another. Some regionally-specificestimates suggest that threshold inflation might be higher in Latin America (23.5%) and Africa (23.6%) than in Asia (5.4% and 11%, in two independent studies).

What this means for policy amid the pandemic

On inflation and financial stability, no conclusion can be crystal clear, especially in turbulent and unprecedented economic times. But from this analysis and evidence, two pointers emerge:

First, that there is little clear justification for the 3-5% inflation targets pursued by the central banks of most emerging market and developing economies—and advocated for by international financial institutions. Financial stability and fiscal prudence matter more than ultra-low inflation.

Second, that in the advanced economies the argument that central banks should show more forebearance of inflation is likely to continue to gain traction. Few will want to risk being accused of bringing economic recovery to a premature end. They show every sign of wanting to restrain inflationary expectations by a sort of modern St Augustine message: we will be virtuous, oh Lord, but not yet. By threatening eventual monetary tightening but not delivering it immediately they will hope to discourage an inflationary spiral while persuading bond markets to keep long-term borrowing costs low. For the time being, this is working, but these are early days.

Mind you, compared with the gargantuan task of unwinding their massive quantitative easing programmes to shrink their balance sheets and restore the credit allocation mechanisms of financial markets, handling inflation may come to seem like a doddle. Or, put another way, not the most important game in town.

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