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The old inflation playbook no longer applies

The writer is vice-chair of BlackRock and formerly chaired the governing board of the Swiss National Bank

Post-pandemic inflation in major developed economies has reached levels we have not had to wrestle with in two generations. Unsurprisingly, this has led to widespread calls for central banks to tighten monetary policy aggressively. Financial markets have quickly repriced their monetary policy outlook and markets now expect at least seven incremental rate rises before the end of 2023.

The debate about how “transitory” inflation would end up being missed the point. The root cause of this rise is more important.

Unlike at any time in the past 40 years, the post-pandemic inflation surge is not principally being driven by excessive demand but by limits on supply capacity, as recent research by the BlackRock Investment Institute shows.

Think of inflation as the noise from the economic engine. In the past, it was caused by the engine revving too fast. Today and for the foreseeable future, it is principally a result of supply-side constraints causing the engine persistently to misfire.

This misfiring occurs at two levels: first, there are economy-wide constraints. In the restart of activity after lockdowns it proved harder to bring supply capacity on stream than for demand to restart. Even more important has been a second sort of misfiring: supply capacity was in the wrong place.

The pandemic caused a sudden, sharp shift in consumer spending away from services towards goods. Capacity — people and capital — cannot be expected to switch sectors so quickly. The result? Bottlenecks in goods-producing sectors as supply struggled to keep pace, but spare capacity in service industries. The constraints on goods supply spark higher prices and while prices may fall in sectors that are suffering, they are typically stickier on the way down. This drives inflation higher even though the economy overall has yet to fully recover.

The US economy finds itself caught in exactly this dynamic. The Covid-19 shock and subsequent economic restart brought on supply constraints of a magnitude greater than for decades. Inflation has risen to levels not seen since 1982. Yet, far from running hot overall, the economy has not even reached its estimated potential level of output and employment.

We therefore find ourselves in a fundamentally different situation from the one Paul Volcker faced when he became chair of the US Federal Reserve in 1979. Then, the economy was running hot and the aim was to drive inflation that had become embedded out of the system.

But this is not a Volcker moment. The old playbook doesn’t apply: today, we are in an era of severe supply constraints even as economies are below their potential. This changes everything from a macro perspective.

When inflation is driven by demand, judicious policy can in principle stabilise both inflation and growth. This is not possible in a world where inflation is the result of supply constraints. Heightened macro volatility becomes inevitable. Central banks have either to accept higher inflation or be prepared literally to destroy demand across the whole economy to ease supply constraints in one part of it.

The long-run historical relationship between unemployment and inflation suggests that if central banks had sought to keep inflation close to their target of about 2 per cent amid the supply constraints experienced in this restart, it would have meant driving the unemployment rate up to double-digit levels.

To minimise growth volatility, central banks will rightly want to live with supply-driven inflation while long-run inflation expectations stay anchored. In fact, recent research suggests that they shouldn’t try to squeeze inflation caused by shifts in demand at all. Inflation helps to smooth the adjustment to big shifts in patterns of demand.

Needless to say, central banks should take their foot off the gas this year by removing the extremely accommodating stance of monetary policy and return rates to a more neutral setting. The resumption of activity — unlike a normal recovery — doesn’t require stimulus to be maintained. But what they should not do at this juncture is slam on the policy brakes, deliberately to destroy activity.

This is precisely the reason why the current monetary policy response to higher inflation has been more muted than in the past. It will probably remain so despite the current excitement about an accelerated pace of policy normalisation. The best approach now is not to destroy jobs and growth with monetary policy, but for economies to reopen as public health concerns ease, returning the mix of spending to normal. This will ease today’s acute inflation pressures.


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