This is the second of two parts. You can read Part 1 here.
AS WE now know, economies around the world responded very differently to the monetary and fiscal stimulus of the lockdown period compared with the those of the Global Financial Crisis. The GFC proved disinflationary whereas lockdown appears to have triggered persistent inflation.
After lockdown, as governments removed the restrictions on economic activity, inflation surged immediately. Initially its cause seemed clear: manufacturers, hampered by logistical issues and labour shortages, were unable to meet the surge of pent-up demand as consumers rushed to make purchases they would otherwise have made during lockdown. This supply-demand imbalance thesis was persuasive for a few months. But as time passed, the supply chains were fixed and the pent-up demand was satiated but the inflation remained. Here in the UK inflation is still holding above 10 per cent, where it has been for almost a year. Something seems to have happened to convert the temporary post-lockdown inflation into an ongoing inflationary process.
Central banks responded to the surging inflation by pushing up interest rates. In the US, since lockdown the Federal Open Market Committee (FOMC) has enacted the most abrupt shift in monetary policy on record, raising rates from 0.25 per cent in early 2022 to 5.25 per cent today. Inflation is now moderating in the US albeit rather slowly. Elsewhere its fall is so far much less convincing.
One explanation for the persistence of the inflation is that the central banks’ interest rate hikes may be causing rather than curing it.6ttttt This is a disconcerting suggestion because it suggests central banks might have misunderstood how monetary policy influences inflation and therefore may be operating monetary policy the wrong way round!
When central bankers use interest rates to manage inflation, they are implicitly using a model of economic behaviour which goes as follows: raising interest rates discourages consumers from borrowing additional money and forces them to divert more of their income to service existing debts. Conversely, lowering interest rates encourage consumers to borrow additional money while lowering the cost of servicing existing debt. Therefore, raising interest rates reduces demand and therefore inflation, while lowering interest rates increases demand and therefore inflation.
This model of inflation responding to interest rate changes is so simple and so intuitive it has become an axiom of monetary policy. It has been adopted as accepted wisdom and is rarely if ever seriously reconsidered. But the model may have a weakness. It may suffer a ‘lump-of-supply fallacy’. It presumes the demand side of the economy is influenced by interest rate changes while the supply side remains largely unaffected.
An alternate model, focusing on the supply side, might go something like this: rising interest rates discourages producers from borrowing money, this curtails production capacity and therefore competitive pressure in the economy, while at the same time imposing higher debt servicing costs. Producers attempt to pass on these higher costs through higher prices and, as competition is less intense, find it easier to do so. Conversely, falling interest rates encourages producers to borrow more money to expand production, while at the same time reducing their interest rate costs. Producers can therefore reduce their prices and are compelled to do so by increasing competition. Therefore, raising interest rates tends to increase inflation while cutting them reduces it.
These demand side and supply side models are very similar. They both assume similar responses to interest rate movements but because they focus on opposite sides of the economy, they lead to different expectations for how inflation responds to interest rate changes.
If conventional wisdom is correct and the demand side of the economy is more sensitive to interest rate changes, lowering interest rates should push up inflation. With a lag, this in turn should then push interest rates back up, which, with another lag, should then push inflation down again. In other words, if the demand side model is dominant, inflation and interest rates should both be cyclical but essentially stationary series and should both move, to some extent, out of phase, with one another.
If the alternate supply side model is dominant, but central banks nevertheless conduct monetary policy according to their demand side model, a very different pattern of behaviour should be expected. A lowering of interest rates should lead to supply side expansion, which in turn will push inflation lower. Central banks will respond with lower interest rates causing a further supply side expansion, another lowering of inflation and so on. Conversely, an increase in interest rates should lead to supply side contraction, pushing inflation higher, causing still higher interest rates. Importantly, this suggests a self-reinforcing or trending behaviour. Once a disinflationary trend is established it will tend to persist until the economy is driven to the zero-rate bound. Once at the zero-rate bound it will become trapped by a disinflationary excess of investment, where it will be stuck until some exogenous shock forces inflation back into the system. Conversely, if an inflationary trend starts it will also tend to be persistent and self-reinforcing again until an exogenous shock reverses its direction.
The journey down to the zero-rate trap will feel like a triumph of moderating inflation, falling rates, rising asset prices and real economic expansion, rather like the great moderation. However, it will terminate in the unhealthy stagnation which gripped Japan after the 1990s.
Which of these models is correct? Does interest rate policy primarily drive the demand side or the supply side? The chart above shows the history of central bank interest rates for the G7 since World War II (blue) together with a global measure of inflation (red). The most striking features of the chart are the long post World War II up-trends in rates and inflation to their peak in the 1980s followed by their long downtrend from the 1990s toward zero, prior to lockdown. This behaviour is consistent with monetary policy acting primarily on the supply side rather than on the demand side of the economy.
Viewed through the supply side model of monetary policy, it is interesting to reconsider the history of interest rates and inflation in the post WWII period. A plausible narrative may be that the end of WWII released an inflationary burst of pent-up demand. Policy makers responded by raising interest rates unnecessarily high thereby preventing the supply side from satiating the higher demand. This situation of high inflation, high interest rates, excess demand and deficit of supply persisted until the 1980s. At this point an exogenous shock hit the economy; for argument’s sake let’s assume this to be Reagan-Thatcher reforms, which caused a sufficiently large supply side expansion to reverse the inflationary trend. From there the self-reinforcing disinflationary expansion of the Great Moderation took hold.
If this supply side is more sensitive to monetary policy than the demand side the current process of raising interest rates may be causing rather than curing inflation. We cannot be certain of this conclusion, but it fits enough of the data to warrant serious consideration. At the very least it suggests we should be more cautious in the application of monetary policy. The US banking system is currently suffering a crisis caused largely by the unprecedented violence of the swing from ultra easy to ultra tight monetary policies of the last view years. These policy swings and therefore the banking crisis itself may have been unnecessary and counterproductive.
We cannot be sure how the levers of monetary policy influence inflation. If we don’t know what the levers do, it might be wisest to tug on them less frequently and less forcefully. An interesting experiment would be to set central bank base rates to, say, 3 per cent and then send our monetary policy committees to the seaside for a decade or two. The economy may perform better without an active monetary policy.
This article first appeared in Equitile Investments and is republished by kind permission.