The success of major advanced countries in dealing with Covid over the last twelve months has been remarkable. Scientists first discovered the vaccines. Then business accelerated their manufacture on an enormous scale. And as the vaccinations have been rolled out, the economic recovery has been dramatic. As new variants appear we are still not out of the woods, but as more people are vaccinated the greater the expectation of a continued and rapid economic recovery and a return to full employment. Last spring the challenge was the need to avoid mass unemployment. This summer the challenge is to prevent a successful recovery presaging a new age of inflation.
For the past three decades we have lived in a world of price stability. Inflation has averaged two per cent a year. For economists this is effectively price stability, because of the constant improvements in the quality of goods and services. One year ago inflation was just a spectre on the horizon. Today it is a menacing cloud hanging over the recovery, which could raise the cost of living and the cost of borrowing for households, increase uncertainty for companies making investment decisions and increase the cost of borrowing for governments.
The idea that a little inflation is nothing to worry about is a dangerous perception. One does not need a hyperinflation to experience the pain of inflation. Once inflation becomes embedded in an economy, the whole population becomes poorer, unemployment rises, those in debt are rewarded and those with savings are penalised. Inflation invariably creates division, conflict and an erosion of trust in society, with everyone blaming everyone else for the chaos. Margaret Drabble captured the turmoil of the mid-1970s in her novel The Ice Age (1977): “All over the country people blamed other people for the things that were going wrong — the trades unions, the present government, the miners, the car workers, the seamen, the Arabs, the Irish, their own husbands, their own wives, their own idle good-for-nothing offspring, comprehensive education. Nobody knew whose fault it really was but most people managed to complain fairly forcefully about somebody: only a few were stunned into honourable silence.”
Most people under the age of sixty have no memory of living through those inflationary times. This includes all members of the present Cabinet, most civil servants and special advisers, most of the staff at the Bank of England and many editors of newspapers, radio and television news and current affairs programmes. Neither do they remember the political struggle and costs of bringing it under control: for the first Thatcher government, this meant bank rate at 17 per cent (Nov 79) and unemployment exceeding three million (1982). It is not surprising that Friedrich von Hayek, the Nobel prize winner for economics, likened conquering inflation to catching a tiger by the tail.
Inflation has returned
The uncomfortable fact is that inflation has now returned in major Western economies.
The publication of 4.2 per cent consumer price inflation for April in the US sent shock waves through financial markets, resulting in a sell-off of equity stocks and a rise in interest rates on US government debt. It was only one observed data point and measured from a low base, but by May it had increased further to 5 per cent. By contrast between 2010 and 2020 annual inflation in the US averaged 1.7 per cent. This increase supported Warren Buffett’s much-publicised opinion that the US economy was “running red hot” and that for companies in which he had invested there was no resistance to rising prices. This over-heating of the economy is against the background of $6 trillion spent on dealing with Covid to date and a further $6 trillion proposed by President Biden as stimulus for the decade ahead.
Inflation is also rising in the UK. The annual rate for consumer price inflation for May was 2.1 per cent, having steadily climbed from 0.3 per cent last November. Factory gate prices rose by 4.6 per cent, input prices increased by 10.7 per cent. Andy Haldane, the chief economist at the Bank of England, has broken ranks with his colleagues on the Monetary Policy Committee and warned that “the beast of inflation is stalking the land”. He argues that the Bank should slow down money creation by phasing out quantitative easing (purchasing government debt in the markets and so increasing monetary aggregates).
In the Euro-area, getting on top of Covid has taken longer, but the recovery is well under way, with demand for goods and services at its highest for 15 years. Inflation for May is expected to be two per cent. In Germany — always wary, after suffering two hyperinflations in the last century — previous leaders of the Social Democrat and Christian Democrat parties are concerned that rising inflation will lead to a serious “social-explosion” which could undermine the German social market economy. The Bundesbank forecasts that inflation could hit four per cent later this year.
The key question raised by the return of inflation is whether the current increase will be “transitory”, as central banks claim, climbing to three or at most four per cent over the next year, but then falling back to two per cent — or whether we are entering a new age of inflation in which inflation keeps rising, feeding through to higher wage demands. This cycle could lead to higher and less stable inflation, possibly accompanied by higher unemployment and lower economic growth.
The US Federal Reserve, the Bank of England and the European Central Bank (ECB) take the first view. Inflation will rise in the short term, they believe, but then return to a stable two per cent. Others are less sanguine and fear that the seeds are being sown for a new inflationary era.
My personal view is that a return to the 1970s, with inflation rates in the upper twenties, is not likely, but neither is a return to a stable two per cent. I believe we face a serious prospect of higher and more variable inflation than we have seen for the past three decades, for many reasons.
The 2 per cent genie is out of the bottle
The first reason is that inflation expectations can are no longer be considered to be anchored at two per cent.
Economists, central bankers and financial markets all expect inflation to rise. So does the general public. For thirty years there has been little discussion of inflation. Now it is impossible to open a newspaper or search a digital news channel without seeing details of the latest price rises: since the start of the year, house prices in the UK have risen by more than 5 per cent, gas by 10 per cent, food by 17 per cent, copper by 26 per cent and petrol by 30 per cent.
Some of the current price increases will prove temporary, due to short-term supply shortages. Some may be longer than expected: microchip manufacturers report that shortages could last at least another year, which will restrict production of cars and electronic devices. Labour shortages have emerged in the UK and the US. There are many unknowns in the recovery from Covid. Yet judged by the criterion that price stability is when people stop talking about inflation, price instability must surely be when people cannot stop talking about it, which is precisely what is happening at present.
For many businesses, especially at the beginning of an inflationary cycle, inflation is welcome, as costs can be passed on to customers and revenues increase. The more inflation edges up, however, the greater the uncertainty about its future direction and the less confidence they can have that expectations of future inflation will remain anchored at 2 per cent.
Paul Volcker, in his 2018 memoir Keeping At It: the Quest for Sound Money and Good Government, recalls an interesting conversation which adds greater precision to the meaning of price instability. In a July 1996 Federal Open Market Committee meeting, Janet Yellen (now US Treasury Secretary) asked the then chairman of the Fed, Alan Greenspan, “How do you define price stability?”. Volcker comments: “To me he gave the only sensible answer: ‘that state in which expected changes in the general price level do not effectively alter business or household decisions’.” We might call this definition the Greenspan test.
At present, if households are making decisions about saving rather than spending, house purchase or improvement or the investments they wish to make, they must take account of the future path of inflation. Similarly, companies wishing to make strategic business decisions must reckon with changes in the level of prices. Because of the sheer uncertainty of future inflation, it is simply not possible for either households or businesses to pass the Greenspan test.
The Federal Reserve, the Bank of England and the ECB all expect inflation to revert to 2 per cent. We need to ask: why? Their sophisticated forecasting models all employ a New Keynesian framework, which in technical language is “dynamic, stochastic and general equilibrium (DGSE)”. The strength of their models is in forecasting the short-term impact of changes in interest rates on aggregate output. The weakness of the models is that they do not explain inflation. The future rate of inflation is assumed rather than determined.
Peter Warburton argues forcefully that in the New Keynesian framework the role of inflation expectations gives too much credence to the influence central bankers can have simply by announcing to the world their desired objectives:
“Modern central banks appear to believe that policy objectives define inflation expectations and that inflation expectations define inflation outcomes. In their minds the inflation rate is detached from the economic system…the strength of their resolve to maintain a low inflation rate is the guarantee of success; hence the importance of the repeated assertions and restated commitments. For them inflation…is a behavioural phenomenon.” (Peter Warburton: ‘Monetary Policy without Anticipation’, Economic Perspectives, March 25, 2021)
Lord (Mervyn) King, former Governor of the Bank of England, expresses the same sentiment with humour: “Forecasts of inflation made by central banks always tend to revert to the target in the medium term. Because they assume rather than explain inflation in the long term, the models are reminiscent of the old joke about the physicist, the chemist and the economist stranded on a desert island with a single can of food. ‘How can we open it?’ The economist’s answer is: ‘Assume we have a can opener.’”
The simple fact is that neither central banks, governments nor the general public have any reason at present to assume that future inflation is anchored at 2 per cent.
The war against Covid has changed the public’s expectations of governments
A second reason to be concerned over the future of inflation is that the Covid pandemic has been a game-changer in terms of what the public wants and expects from governments.
Fighting Covid has been like fighting a war and past wars have invariably been a source of changed expectations. After the First World War and because of their contribution to the war effort on the home front, expectations changed regarding the role of women. In some countries they were granted the franchise, in others they were employed in a far greater range of occupations than before the war, such as the civil service and manufacturing. After the Second World War, which followed the Great Depression of the 1930s, Churchill, who had won the war, lost the peace. Attlee, who succeeded him as Prime Minister, led a government which set up a comprehensive welfare state, including establishing the NHS, completely restructuring schools, creating a minimum state income as well as nationalising swathes of British industry, including coal, steel, electricity, gas and the railways.
Even before Covid, several books — by David Goodhart and Sir Paul Collier in the UK and Robert Putnam, Charles Murray and Anne Case and Angus Deaton in the US — documented the growing financial, geographic and cultural inequalities in society between the successful and those left behind, as well as the failure of society to provide avenues for social mobility.
Against this background, the Red Wall voters in the 2019 election effectively said: “We’ve had enough. We demand change.” The Covid pandemic and the war against it have strengthened and crystallised the expectations of the electorate.
People want greater security in healthcare, welfare, jobs and the environment. The public expect greater resources to be devoted to current healthcare and future resilience against possible pandemics, increased welfare spending on social care to meet the needs of an ageing population, and a commitment to maintain welfare benefits if inflation rises, even if adjustments have to be made to the triple lock on state pensions.
The success of the furlough scheme has meant that the prospect of mass unemployment because of a financial crisis is no longer the catastrophe it once was: it can be “managed by the Treasury”, even though it involves a high cost to the taxpayer. Alongside this is concern over the degradation of the environment, climate change and sustainability of the planet, leading to net zero targets for households, business and society.
And there is the fairness agenda. Levelling up is a response to economic inequality, regional disparities and discrimination. In the US it is the major thrust of Biden’s $6 trillion future spending plan and in the UK of Boris Johnson’s domestic programme. The communiqué of this month’s G7 summit in Cornwall stated that their ambition was to “level up so that no place or person, irrespective of age, ethnicity or gender is left behind. This has not been the case with past global crises and we are determined that this time it will be different.”
When I last sat on the all-party Select Committee on Economic Affairs of the House of Lords, we reviewed HS2, the high speed railway connecting the North and South of England. After taking evidence we were all agreed that this project would never make an economic return. We proposed it should be scrapped. Why, you may ask, is it still then going ahead? I believe it is a response to the public’s new expectations. It is more than a public sector transport infrastructure project: it is a symbol of the attempt to reduce regional disparities and create opportunity for enterprise throughout the UK.
The levelling up agenda is an attempt to tackle inequality. In education and training, it is about greater public provision, not for universities, other than for scientific research and IT, but the need for greater resources for schools, further education colleges, skills training and apprenticeships.
This demand for a fairer economic outcome is global. In the US, President Biden has embarked on a series of projects to renew infrastructure and to create a European-style welfare state. In Italy, Prime Minister Draghi is attempting to bolt on to the economic recovery structural changes in the Italian economy and the governance of the Italian state which create opportunity for wealth creation.
Big state, big spending, big deficits, big borrowing
A third reason to be concerned over future inflation is the scale of the extraordinary fiscal stimulus which governments are now prepared to make.
Biden, Johnson and Draghi have recognised the political implications of the electorate’s changed expectations of governments. Not only have they spent unprecedented sums of money in response to the pandemic itself, but all are equally committed to enlarging the role of the state, increasing public spending as a proportion of GDP, tolerating large public sector deficits and higher taxes on income, wealth and business (though it is consumers and investors who ultimately pay).
At the end of the first session of the recent G7 summit, President Biden won backing from other leaders to “carry on spending” despite having already outlined plans for a staggering $6 trillion over the next six years. Mario Draghi, Italy’s prime minister announced that “there is a compelling case for expansionary fiscal policy” and Boris Johnson declared that the austerity of the past decade had been a “mistake”. The final communiqué was a commitment to “continue to support our economies for as long as is necessary, shifting the focus from crisis response to promoting growth…with a plan that creates jobs, invest in infrastructure, drives innovation, supports people”.
Fiscal deficits across advanced countries are now running at 15-30 per cent of GDP with the UK near the bottom and the US at the top. Deficit spending to deal with Covid for the past year has been, I think, what Keynes would have recommended. Future deficit spending to increase the size of the state is different: it is not simply to avert mass unemployment, but to move to a much more statist society.
By historical standards the Biden response is simply staggering: a $6 trillion increase in public spending over eight years, $8 trillion over ten years (according to a leaked report), following $6 trillion since the pandemic started. This programme is on a par with President Roosevelt’s New Deal (1933-39) and President Johnson’s Great Society (1964-68). Taxes on income and business will be raised to pay for it, but the increase in the deficit is huge. By 2024 the ratio of debt to GDP in the US is set to rise to 117 per cent.
Even among Democrats there is serious concern at the scale of what is happening. Lawrence (Larry) Summers — a Harvard economics professor, formerly Treasury Secretary under Clinton and director of the National Economic Council under Obama — states that: “Policymakers at the Fed and in the White House need to recognise the risk of a Vietnam inflation scenario is now greater than the deflation risks facing the US over the next year or two.” He is concerned that removing this inflation will provoke disinflation and recession, as happened in the US several times in the last century: in the three recessions of the 1950s, the slowdown at the end of the 1960s, in 1975 and in 1980-82. He accuses the Federal Reserve of “dangerous complacency”.
The future course of inflation in the US is relevant to the rest of the world, including the UK. The last time the US experienced inflation in the second half of the 1960s and early 1970s, oil producing countries — holding dollars and seeing their value constantly fall — decided to hike up oil prices. If the dollar falls and US interest rates need to be raised suddenly, this will affect global financial markets, could well lead to recession and will shatter expectations of greater fairness.
As the UK economy grows rapidly, tax revenues will also increase rapidly, reducing the size of the government deficit. Some believe that this will be insufficient so that the only way exceptional fiscal support will be withdrawn is through “the mother of all fiscal tightenings” (Martin Sandhu, Financial Times 24 May 2021). Sandhu also believes, more speculatively, that high demand brings people into work who were previously not in the labour force. Demand creates new supply, so that it would be wrong for the Treasury take its foot off the accelerator any time soon.
Certainly the recovery will reduce the UK deficit through increased tax revenue. However, Boris is no Margaret Thatcher or even a George Osborne. He is a big spending Tory in the tradition of Macmillan and Heath. Even before the pandemic broke, the Conservative manifesto for the December 2019 election rejected any return to austerity. Eighteen months later, following a staggering fiscal deficit accompanied by only modest inflation, the risk must surely be that the policy Boris least wishes to be associated with is austerity.
Grand plans for public spending have to be financed, either by borrowing, higher taxes or inflation. It is this which in my judgment makes an age of inflation more likely.
Central banks’ multiple 0bjectives
A fourth reason for concern regarding inflation is the conflicting objectives with which central banks are now saddled.
When New Zealand introduced inflation targeting in 1990 it followed “Tinberger’s law”, namely that policymakers need one policy tool to achieve one target. In wishing to bring inflation under control it had only one objective, price stability, and one instrument to achieve it, monetary policy.
Today most central banks have multiple objectives. The Bank of England has traditionally had responsibility for price stability. Following the 2008 financial crisis, it also has responsibility by law for monetary stability, as well as for supporting the Government’s objectives of achieving full employment and economic growth. In 2014 the Bank was handed responsibility for competition between banks, and their safety and soundness. In March this year the Bank’s mandate was extended by the Chancellor to include environmental sustainability and helping the Government to reach its net zero targets. The Federal Reserve has a dual mandate to achieve maximum employment and stable prices.
There are a number of reasons against central banks having multiple objectives. Multiple objectives lead to conflict. The central bank cannot simultaneously target price stability and maximum employment. One must be primary, the other secondary. If there is an empirical trade-off between inflation and unemployment, as in the Phillips curve (the lower the unemployment the higher the inflation), the choice should be made by politicians, not central bankers, even though in the longer run there is no choice at all.
In addition, multiple objectives make the boundary between government and the central bank undefined, indistinct and unclear. Decisions taken by government should be taken by elected politicians, those taken by central banks’ unelected officials should be clearly defined and within limits. Central banks should not be required to decide which companies’ bonds they should buy to keep interest rates low or to meet environmental objectives. This route could easily become fiscal policy by stealth.
Multiple objectives also jeopardise the political independence of central banks. I firmly believe that, in general, central bankers would not bow to political pressure. However, central banks have a responsibility to support overall government policy and obviously will wish, rightly, to be seen as team players and responsible citizens. I recognise that the relationship between the Bank and the Treasury is eggshell territory and one proceeds with caution. At a time of crisis it is important that the Bank and Treasury work together, not against each other. But what does a Bank of England Governor do if the Chancellor encourages him to keep interest rates low for a somewhat longer period, in order to ensure the recovery is not put in jeopardy? Do the Bank and the Treasury work too closely together at present? The Federal Reserve does not have this challenge in quite the same way as the Bank of England, because of the way in which it was established as independent of Congress.
Imposing multiple objectives inevitably leads to central banks having conflicts. Multiple objectives get in the way of each other. That is certainly the experience of three hugely respected former central bankers.
The legendary US chairman of the Fed, Paul Volcker, in his memoirs concluded: “A key issue for monetary policy is the degree to which that so-called dual mandate leads to clarity or confusion in the operating decisions of the Federal Reserve Board and the open Market Committee. I fear the latter.”
Ottmar Issing is a distinguished economist and central banker, first with the German Bundesbank and later as a founder of the Euro and the ECB. While he is convinced that central bankers would not bow to political pressure, he believes that they are more exposed to the risk of giving priority to political considerations, such as keeping long term interest rates at a low level for too long: “Exit from the zero interest rate policy will bring central banks into conflict with their governments. It will be a very hard test for the central bank to withstand political pressure and I see a great risk that exit, once needed to wipe inflationary development in the bud, might be delayed because central banks have come closer to political decisions during the financial crisis and now in the context of the pandemic.”
Mervyn King, former Governor of the Bank of England, has also become increasingly outspoken at the threat to central bank independence caused by having multiple objectives: “A combination of political pressure to assist in financing budget deficits, unwise central bank promises not to tighten policy too soon and an expansion of central bank mandates into political areas such as climate change, all threaten to weaken de facto central bank independence leading to a slow response to signs of higher inflation.” (FT 8 June 2021)
Supply side constraints
The fifth reason to believe that we might be entering a new age of inflation is the potential for supply side constraints to reduce real output growth in the face of an extraordinary monetary and fiscal stimulus, such that demand exceeds supply.
If the supply side constraints were simply a ship stranded in the Suez Canal for a few days, Le Gavroche having to close at lunchtime for the lack of staff or the short-term capacity of the chip industry, unable to provide supply until new plants are constructed, the case for concern would be diminished. All of these can be fixed. If interest rates were raised and money supply growth checked, inflation would come down after a period of time.
However, there are longer-term supply side issues. We are much further from free trade than before the 2008 crisis. President Trump’s trade war with China, the protectionist outlook of the EU as a customs union backing “national champions” and a weak World Trade Organisation are very different from the 1980s, 1990s and 2000s.
Brexit enabled the UK to introduce controls over migration. Having introduced a new system of immigration control into the UK, it will prove very difficult to swing open the doors again to allow unlimited numbers of continental Europeans to work here, even assuming they would come.
More importantly the demographics point to an ageing population. In Germany the labour force has been declining for the past ten years. At the beginning of the era of globalisation, 2 billion people entered the global labour market. That has now been reversed.
Supply constraints could be more of a problem in the future that they have been in the past three decades.
No one doubts that the central banks have the means to reduce the growth of monetary aggregates and bring inflation under control. They have done it before and they can do it again.
They are, however, handicapped by having multiple objectives which require them to give too much weight to the political implications of their decisions. This problem has been made even more challenging by a national and international crisis on the scale of Covid. I believe that aggressive monetary easing with zero interest rates and massive intervention in financial markets through quantitative easing was the correct policy response when the crisis broke.
The “V-shaped” recovery is proving stronger than almost everyone expected and inflation is clearly rising. The problem is that we now have two narratives, a short-term narrative embedded in a longer term narrative. The first is the “transitory” view held by central banks. The rise in inflation is temporary, inflation expectations are unchanged, monetary easing will be tightened, interest rates will be raised at a future date and we will return to price stability of two per cent.
This short-term narrative, however, is embedded in a longer-term narrative. Covid has been a game changer. Price expectations are no longer at two per cent. The electorate’s expectations of what governments should provide in health, education, training, the environment and levelling up have changed. Governments are responding with a commitment to a larger role and unprecedented increases in public spending. The multiple objectives imposed on central banks mean they are being drawn into becoming key players in the delivery of the larger narrative, as well as the lesser, which places their independence of government in jeopardy.
The danger now is “too little, too late”. The longer central banks delay in monetary tightening, the more inflation will rise, prompting especially public sector trade unions to demand wage increases greater than inflation, kick starting a wage-price spiral.
The major monetary policy lesson of the post-Second World War years is that it is far better to take one’s foot off the accelerator now rather than slam the brakes on later, jeopardise the recovery and raise unemployment. Executing this policy is not only in the interests of the Bank of England, it is also in the interests of HM Treasury and 10 Downing Street.
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