Opinion – Martin Wolf: Inflation is a political and economic challenge

The return of inflation to the United States is not just a major economic event. It is also political. As it becomes less and less plausible that she will simply disappear without causing pain, difficult decisions must be made about how to react.

This raises big questions. How did we get here? How big and how long will a downturn need to take to bring inflation back under control? Are the policies strict enough? If not, what other measures should be taken? Not least, should inflation be reduced to previous targets or should policymakers give up and raise their targets?

The latest BIS (Bank for International Settlements) Annual Report provides an excellent analysis of what is happening. More importantly, it sheds light on the dangers of moving away from the low-inflation regime of the last 40 years.

By April 2022, the BIS notes, “three-quarters of economies had inflation above 5%. Inflation had returned, not as a long-awaited friend, but as a menacing enemy.” In fact, inflation is already high and widely spread across countries and sectors. At first this was unexpected, and then dismissed as transient. None of the visions caught on well. Inflation is also economically and politically salient. Quite simply, people care about her. Not least, unexpected inflation also means unexpected cuts in real income. This is highly unpopular, which is not surprising.

The danger now is stagflation, defined as a prolonged episode of weak growth plus variable and persistent inflation. To help us better understand the nature of this challenge, the BIS explains the differences between a low-inflation and a high-inflation regime. It does this by looking “under the hood” at how inflation regimes actually work. Crucially, it seems, inflation behaves differently in these two regimes.

When inflation is prolonged low, for example, its volatility also drops, as does its persistence: it is self-balancing. This is partly because people expect it to stabilize, and partly because people often just ignore it. The low volatility of inflation is not due to the low volatility of individual prices, but to the low correlation between them. Relative price changes, even large ones, have little impact on the overall price level.

A high-inflation regime is the opposite. Big changes in relative prices – big currency devaluations, for example – spread rapidly through the economy as people struggle to protect themselves against shocks to real incomes. The mechanism behind this spread is the price-price and wage-price spirals. Furthermore, the greater the concern, the more preventive efforts become. Expectations are crucial. When people no longer know what to expect, they become even more urgently defensive.

Explaining what is happening as due to “exogenous” supply shocks is a big mistake. What is exogenous to any one economy is often endogenous to all of them. Thus, the rapid expansion of demand in several significant economies will create an increase in global demand. Third, excess demand will always show up first where prices are flexible, particularly in commodities, before spreading.

Crucially, we are now on the cusp of a regime shift from low to high inflation. Why did this danger come? One explanation was the overconfidence that inflation would remain low. Another was the old average inflation targeting and overconfidence in the ability to provide future guidance. Another was to ignore money when, once again, it mattered. Yet another was overconfidence in the ability to supply. Of course, there were also clashes, like the war.

The more entrenched this regime change, the greater the costs of reversing it. At worst, a sharp recession or a prolonged downturn may be necessary. So far, policymakers have not made this clear. This is also why they tend to give up before they reach their goal. This is also why prolonged stagflation is now quite likely.

An important question, then, is whether policymakers have done enough to bring inflation down to their targets. Their main argument is that financial conditions are already much tighter. This is closely related to the increase in financial fragility since the stagflationary episode of the 1970s. At the same time, broad money to nominal gross domestic product ratios are still at unprecedented levels, while real policy rates remain negative. It is quite possible that policies will have to tighten up much more in the coming months.

Faced with the need for deeper downturns or tighter policies, central banks may pull back. Politicians certainly will. One possible outcome is a stagflationary cycle, as central banks oscillate between doing too little, reversing, and doing too little again. Another is that many policymakers agree that 2% inflation is too strict. Why not go for 4% or more instead? It would have the benefit of giving central banks more room to maneuver down future interest rates, thus reducing the need for quantitative easing in later recessions.

The argument is attractive, at least politically, but there are strong objections. Giving up when the going gets tough tells people that policymakers will always give up when the going gets tough. In addition, there is the alternative of using negative official interest rates. Above all, say, at 4% inflation will be very evident all the time. In such an inflation-sensitive environment, people will not only find it much more difficult to separate relative price changes from general ones, they will just be waiting for policymakers to fool them once again.

Money is an essential public good. Solid money underpins political and economic stability: it must not be thrown away.

Translated by Luiz Roberto M. Gonçalves