This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists

In an Economists Exchange published just over a year ago, I discussed the risks of an upsurge in US inflation with Larry Summers, former US Treasury secretary. Summers, a staunch Democrat, criticised the Biden administration for the scale of its fiscal stimulus, which would, he feared, lead to significant overheating and then inflation. Subsequent events apparently vindicated his worries.

Olivier Blanchard is among the world’s most respected macroeconomists. Of French nationality, he has been professor of economics at the Massachusetts Institute of Technology and chief economist of the International Monetary Fund. He is currently a senior fellow at the Peterson Institute for International Economics in Washington, DC.

He was one of the leading figures in the creation of “New Keynesian” economics in the 1980s and 1990s. More recently, he has argued that low long-term interest rates mean that it is safe to run larger fiscal deficits than previously thought.

Yet, in February 2021, he, too, warned of the threat of inflation, also stressing the excessive fiscal expansion. So, that is where our discussion began.

Martin Wolf: You were one of the people to warn that inflation was coming. Why did you think this? And have you been proved spectacularly right?

Olivier Blanchard: I thought it obvious at the time that the amount of spending — the $1.9tn size of that bill, which came on top of a bill of nearly $900bn a few months before — was just too large.

It was fairly obvious that this would lead to overheating of the economy. And, where I was partly right and partly wrong is that I had this notion that unemployment would get very low, which it did, that there would be wage pressure and that prices would reflect the higher wages and that this would lead to more inflation.

But I didn’t anticipate the role of the goods market, which is that in many sectors the strong demand led to supply disruptions and very large increases in prices. In the end, inflation came first not from where I would have expected it to come, which was wages, but rather from prices.

People will say, these were accidents that could not have been anticipated, so you don’t get any points for your forecast. But I think that the increase in prices, the disruptions in supply chains, are very much the result of strong demand hitting supply walls.

So, I would claim that I should get a few points for being right in February or March of 2021. Anybody could have come to the same conclusion. I’m happy I did. And then I would admit that inflation has been even higher than I expected, due to this problem in the goods market. A bit of boasting and a bit of humility.

If people did not have the money, they would not have spent it on anything, whether goods or services. But given that they had the money, they spent more on goods than on services. So, that aspect of things, yes, I had not anticipated it. But, if I had known it, then I would have been even more cautious about policy.

MW: In your story fiscal policy is the decisive element. But what about monetary policy? The Federal Reserve insisted until last November that these price pressures were transitory and would soon disappear. Now it is playing catchup.

OB: The question is: what should the Fed have done or said when the fiscal package was passed? I hope that Jay Powell picked up his phone and told the administration that this was going to be an issue.

His staff drank the Kool-Aid, and he, not being a professional economist, could not easily second-guess them. They thought inflation expectations would remain anchored and that the Phillips curve [which shows the relationship between unemployment and wages] was flat. So, even if there was overheating, which some of them predicted, it would not have much effect on inflation.

Even at the time, I argued that the reason expectations had been so stable and the slope of the Phillips curve had been so small was 20 years of no need for action — and so no action. But I think the staff convinced itself, convinced the Board and convinced Powell. So, that’s at the beginning.

If you look at the meetings and press conferences of the Federal Open Market Committee since the middle of 2021, Powell has been a bit more pessimistic each time, and he has been even more strongly pessimistic in the past few months. So, I think he had a sense that more was needed.

They have indeed been playing catchup. But there was a question of how and at what a rate you deliver the bad news.

MW: Do you think that we are talking about a US story, not a developed country story more broadly?

OB: The question is where does advanced economy inflation come from, and my sense is that it largely comes from the US, including the effect of the US on commodity prices. If the US had been more careful, there would have been a much smaller increase in commodity prices. We are focusing on commodity prices at this stage, because of Ukraine, but the rise had largely happened before the war and I think you have to trace it mainly to very strong demand from the US.

The reason I was pessimistic for the US until recently and still think that we will see a tougher scenario than is now expected is that there’s one set of forecasts which will not happen with probability one — those in the Fed staff forecasts of March.

In these, they had unemployment staying at 3.5 per cent throughout the next two years, and they also had inflation coming down nicely to two point something. That just will not happen.

So, what will happen is, either we’ll have a lot more inflation if unemployment remains at 3.5 per cent, or we will have higher unemployment for a while if we are actually to get inflation down to two point something. Clearly, some of the inflation is going to go away on its own. But it will not get back to anything close to 2 or even 3 per cent at that low unemployment rate. So, more action will be needed.

And then the big question is, how strong will aggregate demand be in the US? For the moment, the economy is running extremely hot and the vacancy rate is at levels that have never been seen before. But could a recession come without the Fed doing anything more than it intends to do? It’s not inconceivable.

One point concerns the poor GDP numbers for the first quarter. Now, it’s directly due to export and imports, not consumption or investment. But why did it happen? I don’t know, but if it continued, it would decrease growth. There is also an enormous fiscal consolidation right now. This will clearly decrease demand, regardless of monetary policy.

Yet the reason it’s not obvious that there’ll be a decrease in demand is that there was this enormous accumulation of savings and it’s largely not yet spent. Also, the states received a lot of money in the $1.9tn fiscal package. They haven’t spent much of it either.

Maybe somebody smarter than me could decide how it’s going to play out, but it is not inconceivable that the economy will slow down on its own quite a bit. Unemployment would then increase, and this would decrease the pressure on inflation.

And in this case, maybe the Fed would not need to increase its rates much above 3 per cent. If this did not happen, then 3 per cent nominal interest rates with expected inflation above 3 per cent would not strike me as sufficient to slow down the economy and decrease inflation. So, that’s where I am on the US.

MW: Another factor, I suppose, and you touched upon this one, is what’s going on in the financial markets. There’s a worry that the economy might tank because there’s just so much market turmoil.

OB: When you say there is turmoil in financial markets, what I see is that there is a large decrease in stock prices and an increase in interest rates.

That’s how the monetary mechanism works. I should have added this to the list of things that might slow the economy down. It’s monetary policy working via market anticipation of higher rates to come. Is this going to lead to financial trouble? I’m not a specialist in financial balance sheets, but what I read from the stress tests and other studies is that the financial system can take it.

If financial markets cannot take it, or if governments complained, would the Fed or any other central bank say, okay, we give up and we won’t increase rates? My sense is no. As long as people like Powell are in charge of the Fed, or Lagarde in charge of the European Central Bank, that’s not an issue.

MW: You are associated with the argument known as “secular stagnation”. Is anything happening now leading you to qualify the basic story, or do you take the view that what we’re seeing is essentially a blip caused by the shock of Covid and an inappropriate monetary and, above all, fiscal response to it?

OB: That’s the $1tn question. Your question is, indeed, how much of this is a blip. I use the word bump, which I think has a slightly longer length than a blip. But I believe we will then go back to low real interest rates.

So, on this, I’m going to do the Larry Summers thing. I am going to say, with probability 0.9, we’ll return to something like that world. I think there’s a tendency for markets to focus on the current, on the present and extrapolate it forever. But if I look at the factors behind the decline in real interest rates since the mid-1980s, none of them seems about to turn around, except perhaps one, which is investment.

Suppose that there were a large increase in public investment in the US, because we’ve realised we have to do something about global warming and in Europe, for the same reason. So, this would increase investment. That would increase the neutral real rate of interest.

So, I can think of a new world in which public investment, and perhaps private investment as well, is much higher in the US and Europe. How high? I don’t think terribly high. But I would distinguish between the fact that we’re going to have a period of higher real rates, to slow down inflation, and the question whether we then go back to the same low real rates as before or a bit higher ones. On the latter I’m agnostic.

MW: Let’s move, now, to the European situation and relate it to the war in Ukraine. If you look at eurozone core inflation, it’s gone up a bit on the standard measures, but not very much. So nothing like the US. Given the history and the situation, was the ECB right to contemplate tightening before the Ukraine war?

OB: I think so. They said they would slowly tighten. I thought, at the time — this was February — that this was a reasonable course. Inflation was largely imported into the eurozone, while labour markets were not as tight as in the US. So, I thought that it was a reasonable course of action.

The question is what should the ECB do now. I think there are two opposing forces at work.

The first one is that Europeans seem to be quite relaxed about inflation, thinking it will just go away. And indeed, it might have gone away, had the war not happened. If inflation continues to be so high, there must be a concern about the “de-anchoring” [shifting upwards] of inflation expectations. Other things being equal, that would force the ECB to be tougher than it would otherwise be.

The factor that goes in the opposite direction is that the US is self-sufficient in energy and food, while Europe is self-sufficient in food, but not in energy. We don’t exactly know how much prices will rise as a result of the Ukraine war, but on the assumption that it has caused a 25 per cent increase in the price of energy, that will lead to a decrease in EU real incomes of roughly 1 per cent. This is likely to have an adverse effect on demand. So, this says the European economy might slow down on its own.

At this stage, it seems to me, the two factors are of roughly the same strength. But I would wake up every day if I were Christine Lagarde and look at the new numbers and be ready to move one way or the other.

Okay, so interest rates are going to increase in the eurozone. I have no doubt about that. But, more importantly, spreads are also increasing: the Greek 10-year spread has increased by 93 basis points so far this year, and the Italian by 67 basis points over the same period.

That could put the ECB in a difficult situation. Their position has been that if the rise in spreads is not due to fundamentals, but just to markets becoming dysfunctional or crazy for some reason or another, they would do what it took to keep the rates low. But if it were due to fundamentals, they say, it’s not something they could deal with.

So, what are they going to do if the spread on Italian bonds, say, goes up by another 100 basis points? Is it fundamentals? Is it really a worry about Italian debt, or is it just investors being edgy? It’s going to be very difficult if the ECB is faced with a large increase in spreads, because the only way they could do the right thing would be to say, well, we think its fundamentals are fine and we think investors are wrong.

That’s really hard for the ECB to do. My sense is that the assessment of whether it’s due to fundamentals or is just noise should be left to somebody else — the European Stability Mechanism, for example. You choose your institution, but that looks to be the right one. And then it would send signals, saying, “no, we think that Italy is not in such trouble.” And then the ECB could continue to buy Italian bonds or keep Italian bonds.

But that may well come as an issue in the next six months, and I don’t think that the ECB is in a position to do what it would need to do.

It’s fascinating, this worry of investors, with respect to Italy, for two reasons. The first one is, Mario Draghi is in charge. He is not in charge forever, but he is in charge, and this is not exactly a crazy man, right. And the second is, because inflation is so high in Italy, the debt-to-GDP ratio will almost surely decrease substantially this year and next year. Worrying about the stability of the debt in Italy in the current context strikes me as rather strange.

MW: The war has created some very big dilemmas in terms of how to do sanctions and how to bear the impact of sanctions on the European economy. And of course, some economies are much more exposed to exports of Russian gas, in particular, than others. Italy and Germany are very exposed. France, much less so.

Do you have your own view on what Europe needs to do in the short, medium and long runs to handle this set of potential crises and the trade-offs involved?

OB: Yes, I came out with a paper with Jean Pisani-Ferry on that.

I have a sense that the implications may be much bigger for the long run than for the short run. I am struck by how this is going to change Europe in ways that also matter for the economy.

I think somebody said “we are in a world of deglobalisation, but the implication might be that we’re going to get a more European globalisation”. I very much agree. I think that may strengthen the links within Europe. We’ve learnt that many of the major decisions must be taken at the EU level. So, I think it has strengthened Europe enormously.

Now, coming to the short run, the main economic effect is on energy and food prices. I also don’t think we should take as given that the price increases we’ve seen are going to continue. They might reverse if there is a recession in China. But for the moment the main issue is energy prices.

It’s much better to go after Russia on oil than on gas. And the reason is fairly simple, which is that if we put a tariff on oil from Russia, then Russia will not sell us oil because it would have to take the decreasing price to offset the tariff. So, it’s going to look for other markets.

We know that China is willing to buy some, India is willing to buy some and so on, but they are not willing to do it at the normal world price, and shipping companies are not willing to deliver the Russian oil at the usual price either. So what we would see is a decrease in the price of oil to other markets: the “Ural” price of oil has a discount of about 35 per cent.

In that scenario, I think what happens is that Russia continues to sell what it can, but accepts a decrease in revenues of 35 per cent, which is substantial. But the world supply of oil doesn’t change very much, and to a first approximation, this gets you a decrease in Russian revenues without much of an increase in the price of oil worldwide.

For gas, it’s more complex, because when we put a tariff on gas, it may well be that Russia increases its price. And here, I think, the cross-country distribution issues also make it harder to manage.

Russia is a small player in a rather competitive market, worldwide, for oil. But in the case of gas, they’re facing an incredibly inelastic demand for gas. It’s clearly less elastic than in the standard monopoly condition, which is that the elasticity of demand has to be at least, greater than one, since otherwise the supplier could impose an infinite price.

The reason Russia has not done this is that if it chose an extremely high price, that would increase revenues in the short run, but it would decrease them in the long run as demand and supply adjusted. Russia faces this inter-temporal trade-off. That’s the reason the price of gas from Russia has not been incredibly high so far.

But since it’s likely Russia will not be able to sell gas to the EU in the future, and because it needs more revenues now, I think it has an incentive to substantially increase the gas price. We shall see.

The long and the short of it is that we should be very aggressive on oil, but more careful on gas. In terms of revenues, oil revenues are also much larger than gas revenues, so I think that’s the way to go.

The above transcript has been edited for brevity and clarity.

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