Lessons from our past inflationary episode

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Greetings. Central banks are all holding fire: the European Central Bank last week, the Federal Reserve yesterday and, in all likelihood, the Bank of England today. The policy question has become not whether to cut rates but when. And I observe that my colleagues, too, think it is appropriate to cut rates this year. As readers know, I always thought it was wrong to tighten into what I saw as supply-driven inflation. So if “team transitory” and “team persistent” are finally on the same page about what to do next, how should we today judge their earlier disagreement? On the one hand, I could say “we told you so”, where “so” refers to inflation coming down faster than people thought without any need for unemployment going up, and that we wouldn’t need to loosen now if we had tightened less in the first place. On the other hand, they could say “when the facts change, sir” and make references to stopped clocks. Rather than point-scoring, below are some lessons, observations and self-criticism I propose to draw from the inflationary episode — and I tease out some puzzles that remain unresolved.

First lesson: The inflationary episode is over and has been behind us for a few months. As I pointed out last week (and see Numbers News below), prices stopped rising as last summer turned to autumn. We should not misinterpret the gradual slowdown in year-on-year measures as saying there is still some way to go.

Second lesson: Does this vindicate team transitory? If it really is all over, the period of prices rising faster than central banks’ target rate will have lasted about two years. That is not long. It is entirely consistent with a couple of big supply shocks cascading through the economy as different sectors are affected in different ways. It is also entirely consistent with “excess demand” never having been a problem.

In other words, the price behaviour we have observed is supremely unsurprising from the perspective of my argument in 2021 that price pressures were supply-driven, not demand-driven and would go away by themselves as the ketchup-bottle economy asserted itself. So I think I pass the tests I set for myself back then and renewed in June 2023, when I gave each supply shock 14 to 16 months to work its way through the system through temporarily higher inflation. There were, of course, several supply shocks that could not have been predicted in advance (Russian President Vladimir Putin’s first throttling of gas in late 2021, then his energy war in 2022, and his invasion’s effect on food commodity prices). What we have seen fits nicely with the latest Geneva Reports’ modelling of price shocks that cascade from one sector to another. If anything, two years is surprisingly short for all these shocks to be processed.

Third lesson: Nevertheless, I was wrong in thinking that by now, central bank monetary tightening would have had an effect on demand and employment. (For those who think it’s thanks to central bank tightening that inflation is over, read on to the next point.) But note that both sides of the debate were wrong about this. I (and others on team transitory) thought raising interest rates would unnecessarily sacrifice income growth and jobs, since inflation would go away by itself. Team persistent thought it would sacrifice them as the unavoidable price for getting excess demand and, therefore, price pressures down. We were all blindsided by how well real activity has weathered the rate rises, especially in the US. Admittedly, growth has stagnated in Europe — but it’s hard to identify whether that is because of rates, energy prices (which rose particularly strongly in Europe), general uncertainty because of war in the region, or something else. And in any case, there are no job losses: on the contrary, some economies have record employment.

Fourth lesson: That means monetary policy cannot have brought inflation down through its effect on the labour market, because there was no such effect. So what do you have to believe if you think “monetary policy did it”? Many of those who called strongly for central bank tightening earlier suggest that the fall in inflation vindicates their earlier analysis. But it can’t do so if the causal mechanism they predicted didn’t materialise.

The cleanest account of how central bank policy produced “immaculate disinflation” — disinflation without a recession or even much of a slowdown — would say that central bankers were such convincing communicators of their intentions that people just started expecting inflation to be lower, and lower expectations automatically discouraged businesses and workers from bidding up prices and wages. In other words, central banks worked straight on people’s minds. The problem with this view is that medium-term inflation expectations never moved that much in the first place, and that, like all things immaculate, it seems just a little too miraculous. Call it the Jedi central bankers theory: “These are not the price pressures you are looking for.” It is also an (in)conveniently unprovable explanation.

Fifth lesson: The US and the eurozone have had remarkably similar inflation processes. Paul Krugman points out that comparing like-for-like, the rise in the price level since the start of 2020 has been exactly the same in the eurozone and the US, except that the former lagged behind the latter by a few months. The same can be said about their monetary policy. What differs is that Europe has had a bigger negative energy price shock, and the US has had bigger fiscal stimulus. I have argued that the fiscal policy difference has played the biggest part in the US’s huge growth outperformance relative to Europe; at the very least, we should conclude that it was always wrong to deem the US’s pandemic fiscal response excessive.

Sixth lesson: Given that contemporaneous price growth is now below the 2 per cent target rate of central banks, and on some measures is negative, we shouldn’t be too sure yet that central banks didn’t go too far and are still about to inflict delayed damage, regardless of how exactly their monetary policy affects real economic activity.

Seventh lesson: The upshot is that we don’t understand how monetary policy works in today’s economy. At least we should hope we don’t, for if it does turn out to work like we used to think it does, we should soon see things get a lot worse as higher rates finally start biting and throwing people out of jobs.

Putting it all together, I think it remains plausible to argue that central banks never needed to tighten as much as they did. Conversely, it was wrong to think economies needed to slam on the growth brakes to safeguard price stability (although the growth brake itself seems not to be working). What do Free Lunch readers think? Let us know!

Other readables

Numbers news

• The eurozone economy flatlined in the fourth quarter, with a contraction in Germany offsetting growth in Italy and Spain.

• The single currency’s inflation keeps falling — France yesterday reported year-on-year inflation falling to a two-year low of 3.4 per cent. In Germany, the year-on-year measure fell to 3.1 per cent. But heed my advice from last week and look at the actual price levels for France and Germany, and you will see that in both countries prices stopped rising altogether in September and remain lower today than in August or July respectively. Inflation isn’t slowing, it has been dead for half a year.