Inflation is a political challenge as well as an economic challenge

The return of inflation is not just an important economic event. It is also a political one. As it becomes more plausible that it will disappear without pain, difficult decisions must be made on how to respond to it.

This raises big issues. How did we get here? How big and substantial will a slowdown be needed to bring inflation back under control? Is the policy strict enough? If not, what additional steps may need to be taken? At the very least, should inflation be lowered to previous targets or should policymakers give up and raise their targets instead?

Bar chart of Change in core and headline consumer price indices between May 2020 and May 2022 (%) showing that the US and UK saw the largest increase in core prices in two years

The latest Annual report of the Bank for International Settlements provides an excellent analysis of what is happening. More importantly, it explains the risks of moving away from the low -inflation regime over the past 40 years.

By April 2022, the BIS said, “three quarters of economies will experience inflation of more than 5 percent. Inflation has returned, not as a long -sought friend, but as a threatening adversary. ” In fact, inflation is so far both high and widely spread across countries and sectors. It was initially unexpected and then discarded as temporary. None of the views are broken. Inflation is also noticeable economically and politically. Quite simply, people care about it. At the very least, unexpected inflation also means an unexpected reduction in real incomes. Not surprisingly, it is highly unpopular. (See charts.)

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The risk today is stagflation, defined as a prolonged period of weak growth along with variable and ongoing inflation. To help us better understand the nature of this challenge, BIS explains the differences between a low inflation regime and a high inflation one. It does this by looking “under the hood” at how inflation regimes work. Importantly, it turns out, inflation behaves differently in these two regimes.

When inflation has been low for a long time, for example, its volatility also decreases, as well as its persistence: it is self-equilibrating. This is partly because people expect it to be stable and also because most of the time they just ignore it. The low volatility of inflation is not due to the low volatility of individual prices, but to the low correlation across them. Related price changes, even large ones, then have little effect on the overall price level.

Line chart of Year-on-year % growth in divisia M4*, with Treasuries showing The jump in the broad US currency during the pandemic was remarkable

A regime of high inflation is the opposite. Large changes in relative prices – large declines in the value of money, for example – are rapidly spreading throughout the economy, as people struggle to protect themselves against real income shocks. The mechanism behind this spread is price-price and wage-price spirals. Moreover, the greater the concern, the sooner the efforts become. Expectations are important. When people no longer know what to expect, they become more defensive.

Explaining what happens due to “exogenous” supply shocks is a big error. What is exogenous in any one economy is often endogenous in all of them. Thus, the rapid expansion of demand in a number of significant economies will create a surge in global demand. Third, excess demand will always appear first where prices are flexible, especially on commodities, before spreading.

Broad money line chart (M3) as % of nominal GDP showing The pandemic brought huge jumps in the ratio of broad money to GDP

More importantly, we are now at the peak of the transition from a low to a high inflation regime. Why did this danger come? One explanation is overconfidence in keeping inflation low. Another is the backward targets of average inflation and over -confidence in the ability to provide forward guidance. Another ignores money when, again, it matters. Another is overconfidence in supply capacity. Of course, there are also shocks, such as war.

The more entrenched such change is in regimes, the greater the costs of its return. At worst, it may take a sharp setback or a prolonged slowdown. So far, policymakers have not clarified this. This is also why they are likely to give up before they achieve their goal. This is also why a prolonged stagflation is likely now.

Goldman Sachs Global Financial Conditions Index* line chart showing financial conditions tightened sharply this year

An important question then was whether policymakers had done enough to lower inflation to their targets. The main argument they have is that financial conditions are tightening drastically. That’s closely linked to the rise in financial vulnerability since the stagflationary episode of the 1970s. At the same time, the ratios of broad money to nominal gross domestic product are at unprecedented levels, while real policy rates remain negative. It is quite possible that the policy will have to be tightened drastically in the coming months.

In the face of the need for a deeper slowdown or tighter policy, central banks may be surprised. Politicians will certainly do. One possible result is a stagflationary cycle, as central banks rotate between doing too little, reversing, then doing too little again. Another is that many policymakers agree that 2 percent inflation is too strict. Why not go for 4 percent or more instead? This will have the benefit of giving central banks more room for downward maneuvering in future interest rates, thus reducing the need for quantitative easing in subsequent declines.

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The argument is enticing, at least politically, but with strong resistance. Surrender when the situation is difficult tells people that policy makers will always give up whenever it becomes difficult. Furthermore, there is an alternative to use negative policy rates instead. More importantly, at, say, 4 percent inflation will be very apparent all the time. In this inflation-sensitive environment, people will not only find it difficult to separate relative from general price changes, but will simply wait on policy makers to deceive them again.

Money is an important public good. Good money strengthens political and economic stability: it should not be thrown away.

martin.wolf@ft.com

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