Central Bank Interest Rates – more increases in the horizon

Jerome Powell US Fed Chair increased the Fed Funds Rate by 0.75% last week to 3.25% and has signalled that he will do what is required to get the inflation rate down to the 2% target. Policy rates are still negative almost everywhere, the main exceptions being China, Brazil, Hong Kong, and Saudi Arabia. Mexico and Indonesia are almost there, too.

Thoughts from the Frontline – Mauldin Economics.

If there is a negative real interest rate, it means that the inflation rate is greater than the nominal interest rate. If the interest rate is 2% and the inflation rate is 10%, then the borrower would gain 8% of every dollar borrowed per year. In the early 1970s, the US and UK both reduced their debt burden by about 30% to 40% of GDP by taking advantage of negative real interest rates.

It is possible to control inflation while keeping real rates well below zero but it is more likely that reducing demand will require raising real rates at least to 0%, and probably a bit higher. Higher interest rates globally are on the horizon as at present they aren’t high enough to significantly reduce inflation pressure in most countries. Central banks have work to do.

Source: Mauldin Economics

Shrinkflation

From the PBS NewsHour Paul Solman looks at shrinkflation with some great examples. Shrinkflation is a rise in the general price of goods per unit of weight or volume, brought about by a reduction in the weight or size of the item sold. One of the most famous was in 2016 when the Toblerone reduced a 170g bar to 150g, while the 400g bar shrunk to 360g. This was done by enlarging the gap between the chocolate triangles.

Inflation and potential drivers

Interesting set of charts here that I picked up from Mauldin Economics. The left hand chart shows annually from 2019 and 2021 inflation change against the change in government disbursements. Countries with larger stimulus packages tended to experience greater inflation acceleration. Compared to other countries New Zealand had the largest fiscal stimulus with a disbursements gap of approximately 19% indicating that government spending and transfers increased sharply relative to pre-pandemic trends.

The right panel of that graphic plots inflation vs. the change in employment. A positive
unemployment gap implies that a country’s labour market has yet to recover from the pandemic recession. Across countries, the size of the inflation acceleration is negatively correlated with the unemployment gap, suggesting that differences in labour market slack account for a significant part of the cross-country variation in inflation acceleration.

Source: Mauldin Economics

Is there stagflation in the global economy?

Below is an interesting graphic from the FT which shows GDP and Inflation over the last couple of years in New Zealand – you can select other countries as well and it is good to compare different parts of the world. Note that NZ’s inflation and GDP is lower than the global average. You would normally experience stagflation when the stagnant growth is accompanied by high levels of unemployment – NZ has 3.3% unemployment. However the labour markets globally are very tight with just today British Airways cancelling 10,000 flights due to labour shortages.

If you look at Japan you will see very little difference between GDP and Inflation and you could say they may be eventually coming out of a deflationary period.

The site is very good and has various interactive graphs – Global Inflation Tracker

Global supply-side pressures starting to ease

At the heart of the rise in inflation over the past year has been supply-chain issues as well as the war in the Ukraine. However there are signs that this inflationary pressure is starting to subside with the cost of transportation coming down as well as improved delivery times for produce. The major concern was the COVID lockdown in China and now that restrictions have eased production and the transportation network have returned to some sort of normality. Oil and a number of other commodity prices have declined in recent months due to easing supply-side pressures and expectations of lower global demand, although prices remain elevated.

RBNZ – August Monetary Policy Statement

Global interest rates in sync

Below is a graphic from the IMF showing both developing and developed countries interest rate movements. Obviously during the the COVID pandemic interest rates were lowered to stimulate aggregate demand and reduce the debt burden on consumers and businesses. However with inflation now being well above the 2% threshold that most countries have as their target, interest rates have been on the rise. Central banks need to act resolutely to bring inflation back to their target, avoiding a de-anchoring of inflation expectations that would damage credibility built over the past decades. Although the war in Ukraine and the supply chain disruptions can’t be resolved by central banks, higher interest rates can slow aggregate demand and therefore reduce inflationary pressure.

IMF – Central Banks Hike Interest Rates in Sync to Tame Inflation Pressures – 10th August 2022

Causes of recessions and how do you manipulate the economy for a ‘soft landing’?

Below is a very good video from CNBC that covers the main causes of recessions – overheated economy, asset bubbles and black swan events. Good analysis of soft and hard landings as well as the wage price spiral effect.

“History teaches us that recessions are inevitable,” said David Wessel, a senior fellow in economic studies at The Brookings Institution. “I think there are things we can do with a policy that makes recessions less likely or when they occur, less severe. We’ve learned a lot, but we haven’t learned enough to say that we’re never going to have another recession.” As the nation’s authority on monetary policies, the Federal Reserve plays a critical role in managing recessions. The Fed is currently attempting to avoid a recession by engineering what’s known as a “soft landing,” in which incremental interest rate hikes are used to curb inflation without pushing the economy into recession.

Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Will inflation stay above pre-pandemic levels?

With inflation above double figures in many economies and central banks tightening monetary policy will consumer prices fall? Some economists believed that the inflation figure is transitory and that the surge in prices would quickly decline with the increases in commodity prices falling out of the year-on-year comparison. The US Fed expects inflation to fall from 5.2% at the end of this year to 2.6% by the end of 2023. Predicting the effects of shocks and monetary policy on the inflation rate has become very difficult.

Alternative Macro Signals construct a “news inflation pressure index” which measures how frequently price pressures are mentioned in the news media. In the US and EU the index is still well above 50, indicating that inflationary pressures are continuing to rack up. There are those who believe that inflation will not return to pre-pandemic norm of low stable price growth – 3 indicators suggest this:

  1. Rising wage growth: Bank of Spain suggest that half of the collective-bargaining deals signed have clauses which tie wages to the level of inflation. Other examples of high pay demands include IG Metal in Germany and rail workers in Britain. The G10 group of countries has had a very steep rise in wages increases from the previous year. Minimum wages are increasing in both Germany and the Netherlands. Australia’s industrial-relations agency has increased the minimum wage by 5.2%.
  2. Public expectations: with higher wages there is an expectations of higher prices – Canadians are predicting 7% inflation whilst Japan 20% (previously 8%) believe prices will go up significantly.
  3. Company expectations: retailer inflationary expectations are on the rise. Bank of England suggest clothes prices will be 7-10% higher than a year ago but are customers willing to accept such price increases.

However there is some hope with supply chain pressures easing – cost of shipping from Shanghai to Los Angeles has fallen by 25% since March. Retailers have stocked up on inventory and cutting prices to sell stock. In the US car production has increased which should ease the pressure on the highly inflated used vehicle market.

Source: The Economist – Why inflation looks likely to stay above the pre-pandemic norm. July 2nd 2022.

Inflationary Expectations – Households v Economists

In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices.

At a recent press conference US Fed chair Jerome Powell expressed concern about expectations”
“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

A recent IMF blog post by Carlo Pizzinelli looked at the inflationary expectations of consumers against those of policy makers. When monetary or fiscal policy are in the news how do consumer expectations for inflation change? Additionally how do economic events influence expectations? Can we say that consumers form the same expectations as those who deliver policy decisions? The researchers asked consumers to consider four speculative shocks and then make predictions about their impact on inflation and unemployment. The four were as follows:

  • a sharp increase in crude oil prices as a result of falling world supply,
  • a rise in income taxes,
  • an increase in government spending,
  • a rise in the US Federal Reserve’s interest rate.

It is an assumption that these shocks are generally understood by consumers. Researchers provided current figures for the rates of inflation and unemployment and asked them to give their forecasts for the two variables over the following year. They then provided news about one of the four speculative shocks and asked them to make new predictions for inflation and unemployment.

Results show that there are large differences in expectations from consumers and experts. Of note is consumers belief that an increase in income tax and interest rates would increase inflation which is contrary to what experts predict – see Chart 1.

In order to look into why there is a disagreement between two groups consumers were asked as to what they were thinking when they made their predictions – a focus was on demand side v supply side theory. Experts drew on their technical knowledge whilst consumers rely on personal experiences. Consumers believe that higher costs (interest rates up) for firms are then added to the price of the good or service. Experts predict a decline in prices as consumers spend less and save more – see Chart 2

It is important that central banks make their statements in a simple language so that there is clarity for the general public – e.g. when a central bank raises interest rates unexpectedly households are under the assumption that this action will lower inflation and their actions will ultimately lead to a reduction in inflation.

Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

  • With the threat of inflation should banks have increased their rates earlier?
  • If they tighten too quickly will that tip their economy into recession and a hard landing?
  • What is the right rate increase for the current inflation figure?
  • How long (pipeline effect) will it take for interest changes to impact the inflation figure?
  • These are the challenging questions that central bankers face in today’s environment.

For more on Inflation and Base Rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Interest rates and controlling inflation

Excellent video from The Economist. It goes through the impact of raising interest rates in an economy – mortgages, spending patterns, inflationary expectations. Also looks at when interest rates in the US went to 19.5% during the 1980’s. There is a fine line between increasing interest rates too quickly and tipping the economy into a recession or being too slow with the tightening process and letting inflation spiral upwards. The video discusses all these points – great revision for the Inflation topic at NCEA, IB and CIE.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Interest Rates and Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Turkish inflation hits 73.5% but not surprising.

Most economists are in agreement that when there is an increase in inflation the central bank increases the base interest rates in order to reduce spending and encouraging saving. This takes money out of the circular flow and should lead to less borrowing and therefore less pressure on prices.

The Turkish lira dropped by 17% this year with three cuts in interest rates since September. This comes as inflation has climbed to 73.5%. So why would you drop interest rates when you have rapidly increasing inflation? President Erdogan sacked the governor of the head of central bank Naci Agbal who had been hiking interest rates to dampen down inflation – he was the third governor to lose his job in the last two years. Erdogan believes that raising interest rates would raise inflation rather than reduce it and he proceeded to cut rates further which saw an even steeper decline in the lira. An argument for this policy could be that the cheaper exports can drive economic growth.

Source: FT4th June 2022

The collapse of the lira make exports competitive and imports more expensive and in September Turkey posted a current account surplus thanks in large to a recovery in tourist numbers. Turkey relies heavily on imports of raw materials and energy and with the exchange rate falling these have become a lot more expensive. Although Turkish exports should be cheaper, the heavy import component of finished exports makes those goods more expensive so this outweighs the benefits of having a cheaper lira – e.g. in assembling kitchen appliances the price of imports of the component parts make the overall price of the appliance more expensive. This just fuels more inflation. Supermarkets are limiting customers to one item as they know people will stockpile produce with the ever increasing inflation rate.

So with inflation now at 73.5% and and interest rates at 14% this makes real interest rates = – 59.5%. The central bank kept its benchmark interest rate at 14% at its May meeting, extending a pause that followed 5% of cuts last year. This has led to the local population to turn to other currencies – US$ Euro – in order to protect the value of their money. Below is a very good video clip from Deutsche Welle (German World Service) outlining the crisis that Turkey face and how a policy of cutting interest rates has backfired.

BBC Podcast – How do we stop high inflation?

This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:

BBC – The Real Story – How do we stop high inflation?

The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.

Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.

Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Global Economic Outlook

Below is a look at economic conditions in leading global economies. Unemployment is surprising low and with the rise in the cost of living (see inflation figures) this should put pressure on wages. The unemployment rate within the OECD area fell to 5.2% in February, the first time it has fallen below the pre-pandemic unemployment rate (which was recorded in February 2020). The unemployment rate within the OCED had peaked at 8.8% in April 2020.

Inflation, Unemployment and Interest Rates
Annual inflation within the OECD area rose to 8.8% in March 2022, its highest annual increase since 1988. Energy prices have risen by over a third during the past year, while food prices have risen by ten percent within the OECD area. Most central banks have already commenced a tightening programme with the on-going threat of inflation. The Australian Reserve Bank commenced tightening their cash rate in early May, increasing the cash rate by 25 basis points to 0.35%. It is expected that the RBNZ will increase the OCR by 50 basis points next week.

Outlook
If you look at conditions in the major economies you find the following:

  • China – limited growth potential with severe lockdowns
  • USA – higher interest rates could lead to a bust scenario
  • Euro Zone – cost of living crisis
  • Emerging markets – food crisis / famines.

With the indicators looking at recessionary conditions the best news for the global economy would be a withdrawal from Ukraine by Russian troops and an end to a zero-Covid strategy in China. These actions should reduce food and energy prices and therefore save government spending on raising benefits and subsidising food and energy. Economists are fairly optimistic that we will avoid a recession in 2022 as they still have the tools to stimulate if things get worse. However with no end in sight for the Ukraine conflict and interest rates on the rise a recession is on the cards.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation and Unemployment. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Strong US$ bad news for global recovery

The recent tightening of monetary policy by US Fed Chair Jerome Powell to combat inflation has seen higher borrowing costs and financial-market volatility. The US$ has risen 7% against a series of major currencies since January this year – a two year high. It has always been a safe haven currency and with a rising Fed Rate and market rates even more capital could flow into the US increasing the demand for US dollars and therefore appreciating its value. See mindmap below for the theory behind a stronger currency.

Adapted from: CIE A Level Economics Revision by Susan Grant

A high value of a currency makes exports more expensive but does lead to cheaper imports especially of the inelastic nature. But to foreign economies it does drive up import prices further fueling inflation. For developing countries this is a concern as they are being forced to either allow their currencies to weaken or raise interest rates to try and stem the fall in value. Also developing economies are concerned with the risk of a ‘currency mismatch’ which happens when governments have borrowed in US dollars and lent it out in their local currency. However it is not just developing countries that have had currency issues. This last week saw the euro hit a new five-year low with the US Fed’s aggressive tightening of monetary policy. The real problem for some economies is that they are further down the business cycle than the US so in a weaker position.

“While domestic ‘overheating’ is mostly a US phenomenon, weaker exchange rates add to imported price pressures, keeping inflation significantly above central banks’ 2% targets. Monetary tightening might alleviate this problem, but at the cost of further domestic economic pain.” Dario Perkins – chief European economist at TS Lombard in London

Source: Bloomberg – Dollar’s Strength Pushes World Economy Deeper Into Slowdown. 15th May 2022

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on exchange rates and monetary policy. Immediate feedback and tracked
results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Food and fuel prices impact on Sub Saharan Countries

Just finished completing policies for developing countries with my A2 class and invariably with all my economics classes you cannot get away with not talking about the war in Ukraine and the inflationary problems that the global economy is experiencing. The increase in food and and fuel prices hits the developing world the most and could not have come at a worse time as economies around the world are starting to open up after the COVID pandemic. For the developing world, especially in Sub-Saharan Africa (SSA) there is a significant erosion in living standards and macroeconomic imbalances – see graph below. The IMF has identified 3 main areas that the war is impacting countries:

  • In SSA food accounts for 40% of consumer spending with 85% of wheat supplies being imported. Add to that higher prices for fuel and fertiliser.
  • Higher oil prices mean adds $19bn to the regions imports which worsen the current account balance. However the eight petroleum exporting countries do benefit.
  • SSA countries are not well placed to cope with the need for increased government spending which means using more tax revenue. Increasing oil prices have a direct fiscal cost through fuel subsidies and rising interest rates globally make it more expensive to borrow money to keep the economy ‘above water’ let alone for actual development.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

More inflationary problems with Shanghai port chaos

Shanghai is one of the world’s busiest ports and is usually a well-choreographed operation. Containers ships drop off component parts, empty containers and pick-up exports etc. However with the port in total lockdown the number of ships waiting offshore to be loaded and offloaded of goods is quite staggering – see image from Scott Gottlieb (Twitter).

This is the accumulation of 3 weeks when the port is not operational – workers are in lockdown. The effect of this will be to clog up other ports as ships arrive at the same time and are completely out of sync with what is normal.

The graph below shows that twice as many ships are waiting near Shanghai ports as opposed to last year, which was already above average.

Although consumer and business spending has remained strong, the delays will add to inflationary pressure as goods arriving late from China will mean a short supply in the shops. Add to this the Ukraine war and rising energy and food prices and we have a major inflationary problem on our hands. It’s time to ‘batten down the hatches’.

Source: Thoughts from the Frontline – 23rd April 2022

Inflation – should central banks hold off on tightening?

In New Zealand the recently published CPI figures published yesterday saw the yearly inflation rate climb to 6.9%. The main points to note are:

  • Tradeables inflation (imported) – makes up 40% of CPI – 8.5%
  • Non-tradeables (domestic) – makes up 60% of CPI – 6.0%
  • Housing and household utilities increased 8.6 %,
  • Transport increased 14 %,
  • Food prices increased 6.7 %,
  • Petrol prices 32.3%

The continued rise in domestic inflation means that the RBNZ will probably look at another 50 basis points rise later in the year.

Source: IMF

Ukraine War adds another supply shock – are higher interest rates the way to go?
With a second supply shock and inflation globally on the rise (see graphs) central banks have raised interest rates. However the Russian invasion of Ukraine and the subsequent increase in food and energy prices has asked questions of how central banks should approach monetary policy in what is unusual circumstances. Martin Sandbu in the FT suggest that they should rethink how they look at the operation of an economy. He made 3 main points:

  • Are central banks committed to aggressively increasing increasing rates every time there is a supply shock? This has a huge impact on households and businesses.
  • Do central banks know how their monetary policy works? Higher interest rates reduce aggregate demand and therefore easing the pressure on the supply side. However this is difficult to vindicate in that nominal spending has only just returned to pre-pandemic levels and still fell short in the EU and the UK.
  • These supply-shocks are ‘out of left field’. COVID caused greater spending on durable goods and non-durable goods by 25% and 10% respectively. Services remained depressed.

With the energy shortages arising from the Ukraine War there will be a movement away from production and consumption that use coal, oil and gas. Russian coal is already banned and it is likely that oil and gas will follow. Sandbu asks how monetary policy should approach a supply shock of this nature. If lower interest rates makes it easier to relocate resources then that is the best option for central banks. A tightening of monetary policy would make investments in new capacity both more expensive and less attractive as demand growth slows.

Today there are abnormal circumstances – COVID, Climate Crisis, Ukraine War, supply chain problems. These will mean huge structural shifts which can improve an economy’s productivity and lower inflationary expectations. If there are still higher interest rates productive potential would be reduced which would mean added pressure on inflation. Heading into a time of global supply chain problems monetary policy seems to be less effective.

Source: Central bankers should think twice before pressing the brake even harder – Martin Sandbu – FT 20th April 2022

Inflation today – what is the best response?

The Inflation globally has been on the increase and above the target band in most developed economies. This applies to both Headline and Core inflation.

Headline Inflation – all goods and services
Core Inflation – all goods and services excluding food and energy.

Economic theory suggests that inflation could accelerate and return to levels seen in the 1970’s. A lot will depend how policymakers react to the challenge of bringing inflation down to their specific target level – RBNZ 1-3% but CPI in NZ is 5.9%. See chart for inflation breakdown in OECD countries.

Source: IMF

Key reasons for inflationary pressure.

Supply chain bottlenecks: Lockdowns and shipping problems (container shortages) but latterly the demand side has accelerated – economic recovery and demand for durable goods as well as panic buying.

Demand for more goods than services: Much of the inflation has been in durable goods whilst service inflation has only seen a small increase. This is dependent on which country – for instance demand for used cars in the US has soared.

Fiscal and Monetary stimulus: Approximately US$16.9trn of government spending has been injected into the global economy. This is accompanied by expansionary monetary policy (low interest rates) is conducive to more spending and higher inflation. Savings that accumulated during the lockdowns were now being spent. There was a debate between leading economists whether the inflation would be transitory or persistent. It seems that the data now supports those of the persistent camp. Whether it persists depends on central banks.

Labour supply: Labour participation rates have dropped – for instance for every job opening in the US there is only 0.77 unemployed people per job. See previous post – US Economy – potential for wage-price spiral. This is due to continue meaning that there is a job seekers market where there is likely to be pressure on wages.

Russian invasion of Ukraine: Russia and Ukraine are big exporters of food and major commodities so higher prices have been inevitable with major disruptions to the supply either through sanctions or conflict areas. They supply 30% of global wheat exports so prices have been increasing.

Source: IMF

What should central banks do?

Mainstream policy by central bankers should ignore supply-side shocks like higher commodity prices as this is only temporary. When central banks have intervened and raised interest rates they have ended up worsening economic conditions – ECB raising rates post GFC in 2008 and 2011. Already inflation globally is increasing but there is little central banks can do with higher global energy prices. A focus on home grown inflation (core) might be a better indicator to watch as well as the labour market – fast wage growth might mean higher interest rates. Economist John Cochrane argues that bringing down inflation through higher interest rate is a blunt tool, especially when prices have risen predominately through a loose fiscal policy. He states that inflation might get worse if people doubt the government’s ability to repay its debt without a discount from inflation.

Ultimately the outlook for inflation depends on how determined central banks are to rein in inflation and the confidence of the bond market to governments willingness to pay their debts. Below is a good video from the IMF on the inflationary problem.

Sources: IMF – Will Inflation Remain High? The Economist – ‘War and Price’ – March 5th 2022