It’s a heretical notion, but I’m compelled to repeat it at regular intervals: It’s the furthest thing from obvious that Paul Volcker’s rate hikes were the proximate cause of the disinflation that came to define the macro environment across developed economies for nearly four decades.
Some have suggested that’s a straw man — that nobody claims that for Volcker. But really they do. Or if not solely for Volcker, then for the combination of Volcker and subsequent policy developments, including the institutionalization of central bank independence and the adoption of inflation-targeting.
I’m going to recycle some familiar language. Time and again I’ve suggested that, when we recap the hyper-globalization years and The Great Moderation, we may give central banks too much credit. In the grand scheme of things — taking account of well-documented trends in demographics, debt and technology, as well as the disinflationary impact of wave after wave of globalization — it’s not obvious that central banks deserve anything more than a polite acknowledgement in a footnote.
When posed as a question, the notion seems almost ludicrous: Is it realistic to suggest that small panels of technocrats were more influential in shaping the macro landscape over a four-decade period than globalization, demographics, technology, offshoring, deregulation and the corporate profit motive combined?
To me, that seems laughably implausible. And yet analysts and economists make that argument every, single day in one form or another. In fact, it’s the accepted version of events.
It’s through that lens that I’d implore readers to consider ever higher projections for the Fed’s terminal rate this cycle. “It’s not what I would expect but it would not surprise me if the terminal rate reached 6% more,” Larry Summers told Bloomberg Television’s David Westin, for this week’s installment of “Wall Street Week,” which the network seems to imagine is as popular among market participants as SEC football is to college sports fans.
Summers isn’t alone. This week found the market ratcheting terminal pricing higher in and around the November FOMC meeting, after which Jerome Powell put a decidedly hawkish spin on the ostensibly dovish “step-down” narrative. The Fed will almost surely hike in smaller increments going forward, but to a higher destination. The figure (below) shows how expectations have shifted.
Again: It’s higher for longer. The question, as Powell made abundantly clear, is “How high?” and then, later, “How long?” to hold terminal.
But maybe those shouldn’t be the questions. Some regular readers might be tired of hearing this, but it’s possible that central banks simply aren’t capable of controlling inflation. If The Great Moderation was an anomaly, not the dawn of a new epoch, then macro volatility, like geopolitical tumult, was destined for a reset to the historical norm, which I’ve suggested is something akin to chaos.
Between the pandemic and the war in Ukraine, virtually every disinflationary enabler that helped keep price growth subdued for three decades is in retreat. Some of those enablers had deleterious societal side effects which were likewise disinflationary, including the decimation of labor as an economic actor with clout. Those side effects eventually manifested in a restive electorate which, in turn, opened the door to populism on both the political right and left. The right’s agenda is inflationary through nationalism, isolationism and exclusion (e.g., less immigration, less globalization, etc.). The left’s agenda is inflationary too, through untargeted public spending, the re-empowerment of labor and the subjugation of price growth concerns to a more literal definition of “full employment.” You might like the populist right’s agenda. Or you might like the populist left’s agenda. It doesn’t matter for this discussion. Both are inflationary.
Given the above, and considering that, as Powell has admitted, economists actually don’t know that much about what causes inflation and can’t scientifically measure the extent to which expectations for price growth are becoming unanchored, the notion that central banks are absolutely capable of controlling inflation with rate hikes seems a dubious proposition, at best. At worst, it might be absurd.
You could argue that money supply growth is receding, and thereby the monetarist view suggests inflation is poised to retreat, but that’s not an argument for central bank control given that modern central banking abandoned monetarism a long time ago. And besides, I’m not convinced that reining in the money supply is going to do the trick in the presence of geopolitical chaos. There will always be too much money chasing too few goods if the supply of key goods is subjected to unpredictable and severe disruptions due to geostrategic concerns or, less politely, war.
The figure (below), shows UK inflation going back to 1200. Suffice to say it’s been a turbulent ride.
I suppose you could say the last century (give or take) represents an improvement, at least in terms of the absence of deflationary busts. But I’d gently suggest that what the chart shows isn’t any miracle of policymaking, but rather just the evolution and modernization of economies as the world moved away from primitive economic and societal arrangements and abandoned systems subject to various constraints (e.g., precious metals).
Obviously, a return to the sort of spectacular macro volatility that characterized centuries past isn’t especially likely, but it’s entirely reasonable to suggest that a return to a pre-Great Moderation, pre-Pax Americana state is not only possible, but probable. Indeed, there’s a sense in which this is tautological. The Great Moderation is over. So, apparently, is Pax Americana. Why would macro volatility not revert?
There are any number of catalysts that could render monetary policy even more impotent vis-à-vis inflation than it’s proven to be over the past 18 months. If China moves to seize Taiwan, all bets are off, for example. Already, the economic cold war between the US and China is contributing to inflation. But on a grander scale, beyond just the chips and the tariffs, hot wars are inflationary.
All bets are similarly off if NATO is compelled to forcibly expel Russia from Ukraine. I’m not sure this is well understood by many market participants, but occupation in perpetuity on any scale larger than Crimea is a non-starter. Disputed territory controlled and administered to a greater or lesser degree by separatists is suboptimal, but arguably tolerable. By contrast, the current state of affairs, wherein the same territory is annexed and occupied, won’t work. One way or another, Russia is leaving Ukraine proper. It’s just a matter of when and how. Already, the conflict is contributing mightily to inflation via the impact on commodities. But on a grander scale, beyond “just” the oil, gas and grain, hot wars are inflationary.
Finally, note that Donald Trump is reportedly poised to announce his candidacy for the GOP presidential ticket after the US midterms. There’s no reason to believe he’d lose the Republican primaries, and every reason to believe he’d dispute a lost national election. It isn’t out of the question that some members of the US military would support Trump in any such dispute. In my opinion, there’s a non-zero chance that one way or another, the US ends up temporarily run by the Pentagon in early 2025, either due to the successful defense of democracy or the opposite. In such a scenario, trading and settlement of US Treasurys could be subject to disruptions, with unknowable implications for the dollar and near-term inflation expectations. Already, division, acrimony and hopeless partisan rancor are contributing to inflation. But on a grander scale, beyond just the inability to legislate cooperatively to assist the central bank in its efforts to corral price growth, hot (civil) wars are inflationary.
I haven’t heard anyone other than perhaps Zoltan Pozsar suggest that inflation may be largely stochastic going forward, and thereby wholly beyond the capacity of central banks to control. But when you think about how volatile the world is in 2022, and how volatile it’s likely to be for at least another few years, you’re left to wonder how anyone could seriously countenance the notion that a handful of technocrats with no authority to negotiate trade deals, peace deals or fiscal policy, are capable of singlehandedly pulling inflation back lower, let alone managing it in a tight band around an arbitrary target with no help from anyone or anything other than a thoroughly discredited pseudo-science.