Back inflation is transforming the world – 7/5/2023 – Martin Wolf

In high-income countries, consumer price inflation is at rates not seen for 40 years. With higher inflation, interest rates also rose. The era of “long casualties” is over, at least for now. So why did this happen? Will it be a lasting change? What should the policy response be?

Over the past two decades, the Bank for International Settlements (BIS) has provided a different perspective than most other international organizations and major central banks. In particular, he emphasized the dangers of ultra-easy monetary policy, high debt and financial fragility.

I agreed with some parts of that analysis and disagreed with others, but her position on Cassandra was always worth considering. This time, too, its Annual Economic Report offers a valuable analysis of the macroeconomic environment.

The report summarizes the recent experience as “high inflation, surprising resilience of economic activity and the first signs of strong tension in the financial system”. He notes the widely held view that inflation will melt away. Against this, he points out that the percentage of items in the consumption basket with annual price increases greater than 5% reached more than 60% in high-income countries. It also notes that real wages dropped substantially in this episode of inflation.

“It would be unreasonable to expect wage earners not to try to catch up, not least because the labor markets remain very tight,” he says. Workers could recoup some of these losses without keeping inflation high as long as profits are squeezed. In today’s resilient economies, however, a distributive struggle seems much more likely.

Financial fragility makes policy responses even more difficult to calibrate.

According to the Institute of International Finance, the ratio of global gross debt to GDP was 17% higher in early 2023 than it was just before Lehman’s collapse in 2008, despite post-Covid declines (helped by inflation).

Rising interest rates and bank runs have already caused trouble. Further problems are likely as losses pile up at institutions most exposed to real estate, interest rate and maturity risks. Over time, households are also likely to experience higher borrowing costs. Banks whose shares are priced below book value will struggle to raise more capital. The situation of non-bank financial institutions is even less transparent.

This combination of inflationary pressure and financial fragility did not exist in the 1970s. Partly for this reason, “the last mile” of the disinflation journey may be the most difficult, suggests the BIS. This is plausible, not only for economic but also political reasons. Naturally, the BIS does not add populism to its list of concerns. But it should be in it.

So how did we get into this mess? We all know about the post-Covid supply shocks and the Ukraine War. But, notes the BIS, “the extraordinary monetary and fiscal stimulus deployed during the pandemic, while justified at the time as an insurance policy, seems too big, too broad, and too long-lasting.”

I would agree with that. At the same time, financial fragility has clearly increased during the long period of low interest rates. Where I disagree with the BIS is whether “long low” rates could have been avoided. The Bank of Japan tried in the early 1990s and the European Central Bank in 2011. Both failed.

Will what we are experiencing now be a lasting change in the monetary environment, or just temporary? We just don’t know. It depends on the extent to which high inflation was just the product of supply shocks.

It also depends on whether societies long unaccustomed to inflation will decide that reducing it again is too painful, as happened in so many countries in the 1970s. It also depends on the extent to which the fragmentation of the world economy has permanently reduced elasticities of the offer. It still depends on whether the era of ultra-low real interest rates is over.

If not, it might actually be a “blip”. If so, then significant tensions lie ahead, as higher real interest rates make current debt levels difficult to sustain.

Finally, what is to be done? BIS believes in the ancient religion. He argues that we rely too much on fiscal and monetary policies and too little on structural ones. In part, as a result of this, we have pushed our economies out of what they call the “stability region”, in which expectations (at least of inflation) are largely self-stabilizing.

His distinction between how people behave in low and high inflation environments is valuable. Now we run the risk of moving permanently from one to the other. The evolution of events in the coming years will be decisive. That’s why central banks must be very brave.

However, I remain unconvinced by all the tenets of this faith. The BIS argues, for example, that policymakers should have been more relaxed about persistently low inflation. However, this would have significantly increased the chances that monetary policy would be powerless in a severe recession.

It also argues that macroeconomic stabilization is not that important, but prolonged recessions and high inflation are equally intolerable. In addition, a stable macroeconomic environment is at least useful for growth, as it greatly facilitates companies’ planning.

Above all, I remain unconvinced that the overriding objective of monetary policy should be financial stability. How can anyone argue that economies must be kept permanently weak to prevent the financial sector from blowing them up?

If that’s the danger, then let’s attack it directly. We should start by eliminating the tax deductibility of interest, increasing penalties for people who crash financial companies, and making resolution of failed financial institutions work.

However, BIS always raises big questions. This is invaluable, even if someone doesn’t agree.

Translated by Luiz Roberto M. Gonçalves