27/01/2022

Inflation: What’s Next?

Author

Senior Fellow - Economy

After a period of relative calm, the global economy is now under the threat of inflation. The rise in prices opens a period of uncertainty that could have a wide range of repercussions around the world. Eric Chaney, economic advisor to the Institut Montaigne, considers several possible future scenarios.

The rise in inflation continues to defy the forecasts. It is felt across the economy in the US, having reached 7% in December, leading Fed chairman Jay Powell to say "I think there is quite a bit of room to raise interest rates without threatening the labour market", after the 26 February FOMC meeting. In the eurozone, energy prices have pushed inflation up to 5%, but other sectors will follow due to rising costs and wages. Property price inflation has already reached close to 9%.

The causes of inflation are both cyclical and structural

It can no longer be argued that everything will return to normal once the bottlenecks created by the global economic recovery will have been eliminated. Beyond the specific context of the recovery, the drivers of inflation are both cyclical and structural.

First, economic policies remain highly expansionary. The effects of the income support schemes introduced as part of the response to the Covid-19 crisis will persist as households spend the excess savings they have accumulated. On the monetary side, real interest rates are still negative in both the US and the eurozone, while economies are running at full capacity.

Structural factors are also at play: the end of increasing globalization, or even a reversal, as a consequence of serious international tensions; the exhaustion of the pool of cheap labor provided by China; the relocation of industrial activities in response to supply chain disruption risks; and, finally, the rise in energy prices due to decarbonization efforts.

Two possible trajectories for future inflation

It is likely that inflation will reach a peak and then fall, but what happens next is up for debate. I will consider two opposing scenarios. In each, the price path (a curve where the slope is inflation) is shifting upward, due to the structural factors I just mentioned.

In the benign scenario, inflation accelerates and then decelerates as the price level settles into its new growth trajectory. This assumes that wage gains are gradual and do not, in turn, trigger a further increase in prices.

If, however, the latter chain of events were to occur, this would lead to the second, grim scenario, in which the initial shock would be sustained through a wage-price spiral as it did in the 1970s.

The crucial difference between these two trajectories lies in the monetary policy response.

The crucial difference between these two trajectories lies in the monetary policy response. In the benign scenario, the central bank sets the tone by intervening early and not excessively. By tempering demand in an overheating economy and sending a clear signal that sustained high inflation will not be tolerated, monetary policy can facilitate the transition to stable prices without dipping into a recession.

In the event that inflation becomes persistent and excessive, the central bank will eventually have to squash demand in order to stop inflation in its tracks, as happened in the US and subsequently in Europe in the early 1980s, when there was political consensus that inflation had become endemic and needed to be curbed.

Inflation is more than a monetary issue!

Milton Friedman said that inflation is, above all, a monetary phenomenon. This is true if we limit our analyses to the economic chain of events. But in reality, inflation is a distinctly political issue.

In the US, Democrats in the Biden administration are blaming "profiteers" for the rise in inflation. This argument earned a scathing retort from President Obama’s former economic advisor, Jason Furman: "Corporate greed is a bad theory of inflation."

In France, the government has simply frozen gas and electricity prices. This means the difference between market and consumer prices is financed through the budget deficit and a considerable drain on the profits of EDF, the country’s main utility company, which is largely owned by the French state. Polls indicate that purchasing power will be the most sensitive topic in the debates for the country’s upcoming presidential elections, which probably explains the choice to freeze energy prices.

But the politics of inflation control run deeper than an electoral debate on purchasing power. In the long run, the chosen approach to inflation is the result of a social and political consensus. Allow me to provide two examples. In Japan, retail price levels have remained practically unchanged since June 1997. This unyielding price stability is not a matter of national political debate - indirect proof that the "no-inflation regime" is consensual.

In the long run, the chosen approach to inflation is the result of a social and political consensus.

In France, the high inflation experienced from 1968 to 1985 - consistently above 5%, with peaks at 15% - was criticized outside the country, but was hardly debated at home. Domestically, despite their constant quarrels, trade unions and employers considered that the losses in competitiveness caused by inflation would be absorbed by a future devaluation.

Paradoxically, it was precisely the series of devaluations following the election of François Mitterrand in 1981 that contributed to a consensus on the need to "stop the infernal machine" of inflation, in the words of the president himself in March 1983, after a third devaluation of the French franc. Subsequently, Minister Pierre Bérégovoy and Bank of France Governor Jean-Claude Trichet eventually managed to tame inflation.

Forging an anti-inflation consensus will be easier in the US than in the eurozone

It is remarkable that the US Federal Reserve’s shift in position has been so consensual. Of course, full employment and an inflation rate of 7% have helped. I believe, though, that the memory of past political backlash against the Fed’s independence - provoked by the very tight monetary policy implemented by Paul Volcker in the 1980s - also played a role. Immediate monetary tightening is seen as a lesser evil compared to delayed, more brutal action.

Without labor mobility, the eurozone is struggling to achieve full employment across the region.

The situation is different in the eurozone. First of all, some economies are at full employment (Germany, the Netherlands, Slovenia, Estonia, Austria) or close to it (Belgium, Ireland, Portugal), while others are nowhere near (Greece, Spain, Italy, France, Finland). Without labor mobility, the eurozone is struggling to achieve full employment across the region.

But even if it did, the European Central Bank (ECB) would face a major obstacle. It has become the guardian of the spreads in debts between different states - and one that is feared by the markets. Yet it could not adopt even a moderately restrictive policy without first stopping its asset purchases, which could destabilize countries such as Italy.

The contrast with the previous context of low inflation is striking. In the case of low inflation, it is possible to kill two birds with one stone by buying the debts of eurozone countries. On the one hand, this stimulates the economy by ensuring long-term interest rates remain low; on the other, it prevents any attempt at speculation against the most fragile states. In the grim scenario of ever-rising inflation, these two objectives would become mutually exclusive.

Given the levels of public debt reached in the most fragile states - 207% of GDP in Greece, 156% in Italy, 135% in Portugal - it seems likely to me that the ECB would prioritize the stability of the eurozone over decisive action against inflation.

Inflation will force the eurozone to rethink its structure

How does the eurozone get out of this vicious cycle, should inflation become endemic? Francesco Giavazzi and Charles Weymuller, economic advisors to Mario Draghi and Emmanuel Macron respectively, have proposed the creation of an agency tasked with managing the eurozone’s public debts, which would relieve the ECB of this burden. But, as the authors acknowledge, this could encourage an implicit form of debt mutualization.

Fighting inflation in this context would quickly confront the eurozone with its most essential political question: how do we move democratically toward a form of federalism that was rejected during the negotiation of the Maastricht Treaty and that does not have public support? It would be quite the challenge.

Copyright: TIMOTHY A. CLARY / AFP