The Fed and its many critics have at least one thing in common: They both believe monetary policy can be an effective check on inflation.
Critics rarely charge that central banks are incapable of reining in runaway price growth in developed economies. Rather, the derision over the last 18 months centered on the contention that policymakers were, at best, hopelessly behind the curve and, at worst, deliberately behind the curve by virtue of various “shadow mandates.” Either way, policy was derelict, not defenseless. Hapless not helpless.
By contrast, I’ve suggested that, in fact, there’s no guarantee central banks can “always and everywhere” (to hijack a portion of Milton Friedman’s famous axiom) bring inflation under control. If there’s not enough food to eat or oil to go around or if we lack the wherewithal to get the food where it needs to go or the refining capacity to process the oil, then we have problems central banks can’t solve.
Theoretically, central banks can solve such problems by engineering a drop in demand commensurate with constrained supply, thereby balancing the equation. In practice, that’s a questionable proposition in the presence of persistent and severe supply disruptions.
Central banks’ capacity to ameliorate inflation is contingent on two things: Some semblance of adequate supply (e.g., enough food to go around such that loaves of bread aren’t subject to bidding wars and enough labor such that employers aren’t compelled to offer C-suite compensation packages to every new hire, as nice as that’d be) and anchored consumer expectations. If supply is insufficient even in the face of severely curtailed demand and/or if the public adopts an inflationary mindset, central banks will do well just to keep the situation from spiraling totally out of control.
From my perspective, that’s the most damning critique of central banks there is. And yet, so wedded are the Fed’s critics to the notion that central bankers, when they’re not busy being devious, are hopelessly incompetent, that they (critics) miss the opportunity to prosecute the real case. So busy are critics lionizing the likes of Paul Volcker, that they never stop to consider if there’s an even more condemnatory line of criticism. Or maybe they do consider it, but are just too frightened of the implications.
Inflation, as a phenomenon, is independent of central banks and money. It can easily occur in a barter system, for example. In many (most) hypothetical dystopian scenarios, hyperinflation is inevitable for food and energy. We may currently be living out a kind semi-apocalyptic scenario in which logistical challenges related to supply chain disruptions and war mean that some locales (Europe for energy, emerging markets for grain) are experiencing dystopian hyperinflation. The kind of inflation that’s unresponsive to central banks.
“Realistically, given the global nature of the staggering supply shocks, it would’ve been impossible for monetary policy alone to come close to the 2% inflation target from mid-2021 onwards without strongly depressing domestic demand, which may now happen anyway,” Rabobank’s Stefan Koopman and Michael Every wrote, in a noted out late last month. “It’s not just global demand imbalances that are driving low or high levels of inflation, but ongoing geopolitical conflict and the weaponization of commodities and supply chains that will last for many years,” they went on to say.
Koopman and Every specifically addressed the Bank of England’s impossible dilemma, noting that thanks to Brexit and “the lopsided return to business after COVID,” the UK economy has undergone a structural change which entails lower trade volumes, lower productivity and higher odds of labor unrest. Double-digit inflation “will only fan these flames,” they said. Goldman this week warned that in a worst-case, inflation in the UK could reach 20% early next year.
The crucial point from Koopman and Every is captured in a single sentence: “These aren’t short-term ‘supply shocks’ that monetary policy can overlook, or which any level of rates can overcome in isolation.” No level of rates can solve this puzzle.
Of course, not doing anything (or cutting rates) could make things materially worse for a number of reasons, not least of which is the potential for the perception of policymaker dereliction to unanchor inflation expectations. “Cogent arguments are made that raising rates against this kind of backdrop is economic lunacy, but not raising rates against [double-digit] inflation is total abrogation of central bank responsibility,” Koopman and Every remarked. “One might as well not bother targeting inflation at all.”
They aptly (euphemistically, even) called this central banks’ “structural policy dilemma,” before summarizing the situation as follows:
Pre-COVID, even ultra-low interest rates failed to drive productive private- or public- sector capital investment due to debt overhangs and low wage growth, so there was no strong GDP growth and no ‘healthy’ inflation, only asset price inflation. The central bank response was a growing list of liquidity acronyms to paper over these widening cracks. Now, post-COVID and Ukraine, higher interest rates are unable to deal with soaring supply-side inflation, only push demand lower, which ‘helps’ in the most painful way. As such, the question can be asked: ‘What is central bank inflation targeting good for?’ given it only seems to work in a limited set of geopolitical and macroeconomic circumstances.
There it is again: The notion that what an entire generation came to regard as “normalcy” was in fact a peculiarity — an exceedingly unlikely, but highly fortuitous, turn that found the stars aligning to create the conditions for more predictable macroeconomic outcomes.
Romantic comedies, as a genre, owe their popularity to an oxymoron: Serendipity is no accident. That’s why audiences generally come away feeling better about their own lives or, at the least, more hopeful about the chances of finding happiness.
That, of course, is a pleasant fiction. Serendipity is luck. And as a species, our luck seems to be running out.
Read more: What If ‘Normal’ Isn’t What We Think It Is?
In our time, one man’s serendipitous biography is always counter balanced by another’s biography written by Steven King.
We are not actually in a post COVID world yet, particularly as regards China, the supplier of so many of the goods that we were used to receiving in an efficient manner.
If high interest rates crush, truly crush, demand for everything outside of the most inelastic of items would that not free up cheap capital and labor for the expansion of supply for those ‘most inelastic’ items?
Hence the idiocy of monetarist theory. No one policy lever works all the time for all cases – fiscal, monetary and anything else. The ECB cannot make more natural gas available no matter what their policy, in just the latest instance.
If the worst should come to pass vis-a-vis inflation in the U.S. but especially the UK and Europe, than we should consider it a wartime situation and mount nothing less than a full-on wartime response. That would mean temporary nationalization of certain industries, rationing, tighter regulation of certain derivatives., etc. Just sayin’.
I’m currently living in a country where the economy is mostly cash based. Changes in interest rates do not affect the vast majority of the population. Seems that Central Banks should be even less capable of doing anything, including demand destruction, when that is the case.
Great article, great responses: This is why staring in stead of just looking at what economics say is not recommended. At least Paul Krugman calls himself a political economist and does not pretend he is a physicist practicing hard science. Technical analysis may well be voodoo, but a lot of economic writing and fundamental research is worthless. Sometimes the only way to discover the truth is to be wrong and take a beating….
Cue up Two Princes (spin doctors) for our species descent into the abyss. 🙂
Hi – I’d love to hear the author’s take on Jeremy Siegel’s recent inflation comments. I can’t recall if they’ve featured in any recent articles.
I mentioned some of his remarks in one of last week’s week-ahead previews: https://heisenbergreport.com/2022/08/28/poring-pouring-and-poor-ing/
“Theoretically, central banks can solve such problems by engineering a drop in demand commensurate with constrained supply, thereby balancing the equation. In practice, that’s a questionable proposition in the presence of persistent and severe supply disruptions.” Absolutely correct … they think!
In econ 101, I was immediately initiated into the mysteries of supply and demand and how they must balance or bad things will happen (the horror of disequilibrium, nearly as bad as crepey skin). I have taken four macro econ courses all the way up to the doctoral level and for the life of me I still can’t figure out how these guys can differentiate between a change in either supply or demand on one of the curves and levels that change by a movement of the curve. Always seemed like voodoo to me.
The trouble with these guys is that they don’t generally don’t understand how business actually works. Micro economists can tell you about the change in marginal revenue or the change in marginal costs but never once in my memory of micro econ did I hear an economist talk about profits, or the differences in effects that result from changing the types of costs in a firm (fixed or variable), or about the effects of operating leverage. All of these factors are important drivers of the supply of goods and services. It’s not enough to kill demand to seemingly make it balance with supply to “clear the market” and with luck, stabilize prices. What is going to happen as the Fed does its mighty squeeze is that millions of people will lose their homes, lose food security, and lose medical care. And companies will lose profits. They just hate that so at some point, companies will be forced to make strategic adjustments which will negate some or all of what the Fed is doing. What I see as initial adjustments is for firms with inelastic demand to raise prices as high as the market will allow. Other firms are changing their product mix to eliminate unprofitable variety and reinforcing supply chains where needed to protect what remains on the shelves. What the Fed can’t see in their models is what all will happen as firms do this.
Very insightful observation that seems to have been missed by Wall Street strategists. Maybe instead of lionizing Volcker they should be reviewing the history of the failed attempts to bring inflation under control from 1978-1980. Monetary largesse accompanied by fiscal austerity didn’t solve the structural problems of Europe, but doubling down on Q/E was always the outcome. Now we have monetary tightness accompanied by fiscal expansion to fight supply-side inflation. Why does the Wall Street punditry blindly assume its success?