During the pandemic, the central banks of the US and of the eurozone reformed their monetary policy strategy in a major break with earlier practice. After a decade of below-target inflation, and employment taking achingly long to return to earlier peaks, interest-rate setters promised to be relaxed about inflation running temporarily above target so long as ongoing monetary stimulus was otherwise warranted.
This should have steeled central bankers’ nerves in the face of several bad supply-side surprises. And for a while they did keep their cool during the resulting inflationary burst. But they have not sustained the courage of their new convictions. Instead they let criticism bully them into rejecting the possibility that high demand pressure could draw more resources into the economy than previously thought and thus over time help contain price pressures while maintaining growth.
Central banks now seem determined to restore that monetary version of toxic machismo that says if it doesn’t hurt, it’s not working. Leading policymakers are increasingly explicit about intending to bring inflation down even at the cost of slowing growth or putting people out of work. Markets have taken their cue and are bracing for recessions.
Central bankers take no pleasure in this, of course. Their case relies on thinking there is no better alternative. But if so, they had better be absolutely right and unfortunately their argument is weaker than many think.
At first the rise in inflation was near universally attributed to supply shocks. But despite the obvious role of Vladimir Putin’s attack on Ukraine and the subsequent tightening of gas supplies, prevailing opinion has somehow shifted to blaming excessive demand.
Yet it is only this year that nominal spending surpassed the pre-pandemic trend in the US; and it still has not done so in the UK or eurozone. Even in the US, the total volume of goods and services bought (as opposed to their market value) is right on the pre-pandemic trend. Not so much demand running amok, then, as recovering demand (itself a triumph of crisis policymaking) facing higher prices for supply-side reasons.
The obvious retort is that even if demand is near a normal level, supply may not be, either because of the pandemic or energy and commodity price spikes. But how certain can we be that these are durable problems? (It makes little sense to cause a recession to deal with temporary supply hiccups.)
The pandemic could have damaged the economy’s capacity to produce by reducing the number of healthy workers. But not in the eurozone, where many countries enjoy record-high employment rates. And while the US economy still employs almost a million fewer people than in February 2020, the current boom keeps adding jobs at rates more than twice the pre-pandemic average. Job growth remains strong in continental Europe too.
There is little sign of this fizzling out. But central banks could arrest it with their determination to curtail demand growth. So the question arises: is what our economies most need now really to have fewer people in work? Even with the lens of inflation, isn’t letting employment and hence supply continue to grow strongly what is needed to sustainably reduce price pressures?
The same goes for the energy crisis. For net energy importing economies, high oil, gas and power prices make them poorer, so they will have to export more and consume less to provide for their energy needs. How is that problem ameliorated by reducing their own production as well, when contractionary policy hits both employment and investment? (As for countries that are not net importers, higher energy prices cause inequality that monetary tightening can only worsen.)
The last line of argument for tightening into a supply-triggered recession is to avoid a wage-price spiral. But the rationality of this depends on the risk being more than theoretical. By themselves, wage increases are of course something to welcome — and robust profit margins suggest wage costs are not driving prices up. It is also worth noting that countries with the greatest collective bargaining coverage (France, Italy, the Nordics) have the lowest inflation rates.
None of this should belittle the real suffering caused by the cost of living crisis. But monetary contraction on the cusp of a recession will make things worse for no benefit. Governments have to put in place support for those worst hit by the jump in prices. But maybe central banks — for the very sake of monetary and economic stability — should treat inflation with more benign neglect.