Stopping the inflation

Business Standard, 27 June 2022

There is a great inflation around us, worldwide. How hard will it be to wrestle this to the ground? In some ways, it appears that a bloody minded slog is impending. There is much uncertainty and dispersion of views on how this will play out. But there is logic in favour of a cautiously less gloomy scenario.

The pandemic kicked off a strong macro policy response in DMs. Fiscal policy played at World War 2 levels in the US, encouraged by the impending election in November 2020. DM central banks cut rates sharply, and reopened the toolkit of unconventional monetary policy developed in 2008. With the benefit of hindsight, we know that these responses were overdone. Matters were made worse by pandemic and war related disruptions of the supply chain. All these forces came together and kicked off an inflation that is comparable with the 1970s.

India was a great beneficiary of expansionary DM macro policy, as this ignited an exports boom here. In similar fashion, the Indian macro/finance environment is now being reshaped by the global inflation and the DM monetary policy response. We in India need to understand this situation.

Monetary policy is the task of controlling the short-term interest rate of the economy to deliver price stability in the long run. We should express the short-term interest rate in real terms. E.g. in India, when the short rate is 5% and (expected) inflation is at 8%, the short rate is -3% in real terms. The policy rate should generally be positive in real terms to fight inflation.

A nice tool of monetary economics lies in thinking about what happens when expected inflation changes. Suppose expected inflation goes up by 100 bps. If the short rate goes up by only 50 bps, then in effect, the real rate has gone down. This should generally not be the case. This idea is called `the Taylor principle'. Monetary policy must respond by more than the change in (expected) inflation. When inflation drops by 100 bps, monetary policy must respond with a cut of perhaps 150 bps, and vice versa.

With the benefit of hindsight, many central banks played this wrong in recent years. Expected inflation rose but the monetary policy response was not commensurate. The economy overheated and inflation rose, but real rates fell, which further stimulated the economy. Economic agents watched this spectacle, and concluded that central banks were not serious about inflation. Their wage setting and price setting behaviour changed, which fueled inflation.

This is why the US Fed had to engage in shock and awe in recent months. The Fed is trying to claw back to a real rate that is positive, and more primal, a set of months in which the increase of the rate is bigger than the increase of expected inflation, so the real rate goes up. It is trying to claw back its credibility, to get back to a point where there is no doubt about the Fed's objective.

Could this be a bloody minded slog, like an artillery war in Eastern Ukraine, where much misery is induced? Monetary policy only acts over long time horizons, the impact on inflation plays through over 12-18 months. Will the world economy be driven into recession as a side effect of conquering inflation? There are three arguments in favour of a more optimistic reading.

The key thing is how the public sees the Fed: the extent to which the Fed is seen as credibly focused on getting US inflation to 2%, with no extraneous considerations. For a while, it seemed that this was not the case, with words and deeds by the Fed which appeared to stray from the inflation target. That period is decisively behind us. The Fed is back in the game as a normal mature central bank, with no uncertainty about its objective, a 2% inflation target. The recent fluff about climate change or women's employment has been discarded. From 1994 on, the US Fed has had no exchange rate objectives.

This knowledge -- this `mere knowledge' -- in the minds of workers and firms helps to stabilise inflation. Individuals make wage and price decisions, and once there is trust in the objective of the Fed, these decisions will change so as to bring down inflation. Done right, monetary policy is a mind job. Done right, more cruelty is promised than is inflicted. Institutional credibility partly substitutes for pain. This is not just a theoretical construct: there are episodes in history (e.g. Israel in 1985), where the pain required for reducing inflation was remarkably low, through strategies that rearranged expectations of the people.

What about the supply disruption? The market economy is a self-organising self-healing system, and from January 2020 onwards, firms have been modifying their behaviour. As an example, the Baltic Exchange Dry Index, which measures the cost of shipping raw materials, rapidly got back from the peak of 5500 in September 2021 to normal values by December 2021.

The Covid supply chain disruption of 2020 has dragged on much more than expected owing to new developments in China and Russia. For the rest, the price system ceaselessly diagnoses and solves the problems of production. Barring big new shocks on the scale of China's ZCP or Russia's invasion of Ukraine, the reconfiguration of global production is well underway.

Finally, DM fiscal policy tightening is helping. The pedal had been floored in the pandemic, but in the latest quarters we are at more normal values. This reduces the inflationary pressure.

What extreme actions will the US Fed now take? When will macroeconomic stability (i.e. 2% inflation) return, after which normal economic growth can recommence? It is true, the Fed may have to do harsh things in order to get the job done. Three arguments -- the power of a credible inflation targeting regime, the healing of supply chains and fiscal normalisation -- suggest that restoration of stability could be achieved at a lower cost than is widely feared.

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