The specter of inflation has returned. For two decades, central banks across industrialized economies were confident that they had banished it for good. Then came the 2008 financial crisis, which occasioned a brief return of inflation anxiety on both sides of the Atlantic. In the United States, congressional Republicans ushered in austerity in 2010, and the European Central Bank started tightening its interest-rate policy in 2011. But then policymakers started to worry that inflation was too low, and that it might be impossible to reignite.
Now, the inflation chatter is back. But how seriously should one take it? After all, we have been here before, and not just in 2010.
The current debate reprises the confused policy environment of the 1970s, when inflation doves argued that the decade’s oil shocks – prices tripled in 1973-74, and again in 1979, after Iran’s Islamic Revolution – would not produce higher inflationary expectations or an inflationary spiral. Some prominent economists, like the British Keynesian Roy Harrod, even argued that growth-boosting monetary and fiscal policies would lower prices, because output and abundance would increase.
In response, inflation hawks warned against ever-greater monetary expansion, favored by banking and financial interests. The resulting increase in prices would create a ratchet effect in which organized groups – especially labor unions – would lock in higher pay settlements.
A common historical interpretation of this period holds that President Richard Nixon, and later President Jimmy Carter, bullied the US Federal Reserve into pushing for inflation. But Fed economist Edward Nelson’s recent wide-ranging study of the Nobel laureate Milton Friedman and the 1970s monetary debate refutes that interpretation. He shows that Fed Chair Arthur F. Burns, a man of impeccable monetary orthodoxy and a father figure to Friedman, was determined to prevent a new inflationary spiral.
But Burns had a mistaken theory of how inflation emerges. He was confident that the price and wage controls he advocated would control the wage-push effect that might follow from a onetime shock. The Fed thus confronted the Great Inflation of the 1970s with a faulty doctrine. Friedman built a formidable reputation on his prediction of runaway price growth.
Some European countries took a different route. The German Bundesbank, which had been worried about inflation long before the oil shocks, saw an opportunity in May 1973 to end the deutsche mark’s fixed exchange rate against the dollar. At the time, German banks bristled at the move, fearing that it would lead to bank failures. But later, with inflation, and thus interest rates, lower than in the US, German policymakers could argue that the ensuing 1973 oil shock really was a one-off episode. Owing to their initial success, they were in a position to accommodate it, and Germany suffered only mildly during the global downturn in 1975.
Generally speaking, a one-off shock can be accommodated without long-lasting effects, because everyone recognizes that it is an exceptional event. But when there are repeated cycles of shocks and policy responses, a pattern emerges. People’s views of the future start to change as the exceptional becomes normal. In the language of central banks, expectations become unanchored.
Similar arguments have been made about major military engagements, which require large fiscal outlays that push up demand temporarily (that is, for the duration of the conflict). After World War I, the US and the United Kingdom pursued a rapid return to “normalcy,” embarking on a painful process of disinflation. In Central Europe, however, there was deep and lasting political and social fragility, creating the impression that wartime circumstances still remained, and that wartime fiscal responses were still needed. These countries ended up on the road to inflation, and then hyperinflation.
The same reasoning can be applied to the COVID-19 pandemic. There is no doubt that large monetary and fiscal buffers were urgently needed to mitigate the immediate shock of the virus and the attendant economic lockdown. Were the buffer to be withdrawn at some clearly defined moment, there would be no long-term consequences for price expectations.
But like the coronavirus itself, economic malaise could linger as societies continue to suffer from the disease. The impact will not be evenly distributed. The tourism and travel industries will undergo severely delayed recoveries, and thus will demand continuing fiscal support. The challenge will be to distinguish hard-hit but still-viable sectors from economic activities that have suffered a permanent shock as a result of technological developments or behavioral changes.
Though policymakers all recognize the one-off character of the COVID-19 shock, they have begun to diverge on the question of how to respond. US President Joe Biden’s administration is convinced that its proposed $1.9 trillion recovery package (which comes on top of $3.1 trillion of expenditure in 2020) does not pose any long-term danger.
Fed Chair Jerome Powell acknowledges that pent-up demand might trigger a short-term jump in inflation, but he believes this would be temporary, given the experience of the last 20 years. Similarly, the ECB argues that a quick price spike should not be over-interpreted as the return of inflation. As ECB President Christine Lagarde has confidently put it, “It’s going to be a while before we worry about inflation.”
By contrast, some EU member states – especially in the “frugal north” – are beginning to worry about a new and dangerous worldwide inflationary consensus. And some Americans, including former Secretary of the Treasury Lawrence H. Summers, who previously advocated fiscal stimulus, have begun to voice similar concerns.
With the same divergences that accompanied earlier shocks reappearing, we need a simple test to navigate the new-old inflation dispute. The key question is whether we can be confident that the state of exception will end. If we can clearly identify that moment, we need not worry about inflation.
But if one exception begets more exceptions, there will be no clear way out. Instead, expectations will shift, and inflation will increasingly factor into our vision of the future. That will create political uncertainty and acute polarization between countries run by fearful hawks and those run by self-confident doves.
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