In practice, economists know surprisingly little about what drives inflation. Milton Friedman taught us that “inflation is always and everywhere a monetary phenomenon”.3 In one sense, he was spot on: sustained periods of high inflation are the product of unsustainably rapid monetary growth. In another sense, though, his dictum has been a distraction.4 In the era of inflation targeting, monetary forces have proved to be a poor guide to inflation dynamics.5
This inability to forecast inflation, and possibly even understand its dynamics ex-post, has altered how central bankers behave in two key ways. First, when making forecasts and setting policy, central banks now give far greater weight to current developments in price and wage inflation. Second, by reducing the perceived dangers of low unemployment (until there is clear evidence of its effect in wage growth). Because inflation has persistently surprised to the downside and pay growth has remained contained, a future period of above-target inflation has been viewed as low risk, while the dangers of depressed inflation have been amplified.
Shifts in the inflation regime go hand-in-hand with economic disruption. They cannot be disentangled from the political dynamics of the day.
Long gone, it would appear, are the days of “long and variable lags”, where central bankers would look to normalise policy before the economy had reached full employment. They may not be willing to wait until the “whites of inflation’s eyes” become visible (as Larry Summers suggested in 2015) but policy has become highly reactive to past inflation and wage growth. Persistently sub-par inflation has given the upper-hand to the so-called doves in all the major central banks. And it has provided ammunition for those arguing that policymakers should press hard on the accelerator, until there is categorical evidence that inflation is returning to target. Indeed, this is the explicit strategy of the US Federal Reserve under Jerome Powell.6
The Federal Reserve is now withdrawing stimulus and looks set to go further in this cycle. Powell’s Fed may be less dovish than Janet Yellen’s but it is still treading carefully. Short-term real interest rates are around zero, far below historic norms; and, if at all, they will only rise gradually. To anyone with a broad view of economic history, it will seem remarkable that US interest rates are so low (and the Fed’s balance sheet so bloated) in the context of sizeable fiscal stimulus and an unemployment rate just shy of its 50-year low. History would suggest that by now in the cycle one would want macroeconomic policy to be restricting growth.
We have been here before, in the late 1960s. While the reasons have differed in each cycle, the Fed has systematically failed to engineer soft-landings in the post-war period. Policy has moved too little, too late. On some occasions, the cycle has been brought to an end because of rising inflation. On others because of financial excess. Repeatedly, the brakes have been applied hard and fast, late in the cycle, long after economic imbalances have emerged.
Once again, the Fed is underestimating the danger of an overheating economy. A tightening of financial conditions is necessary to slow the economy. That the Fed appears to be blinking (hesitating to tighten further) is telling. It once again reiterates central bankers’ overwhelming fear of the deflationary ditch and the asymmetry at the heart of monetary policy.
This matters because Fed guidance about inflation and the path of interest rates anchors financial markets. Little wonder then that investors attach little weight to the possibility of even a limited burst of above-target inflation. Yet, we have an openly protectionist US president. Leading an administration now devoid of its moderate, globalist faction. An administration that is loosening the fiscal reins at a time of still supportive monetary policy and sub-4% unemployment.
Pricing in bond markets suggests a remarkable degree of confidence in the ability of the Fed to steer the economy to safe harbour.