Stories about inflation
Stories matter whether they are true or not. Especially when it comes to monetary policy.
Charles Goodhart, as I wrote a couple of weeks ago, thinks that economics currently has “no general theory of inflation”. But if the profession lacks a generally accepted theory, it certainly has stories about inflation. And stories, as Robert Shiller has convincingly argued, have power. They are worth taking seriously whether they are true or not.
Looking at current market pricing, investors are definitely leaning more towards the “not transitory” side in the great – and ongoing – “is above-target inflation transitory or not?” debate. Still, I think the debate is far from settled. And more importantly, I think it is worth constantly keeping in mind that transitory does not necessarily mean “short-lived”. Inflation could be above target for 12-24 months and, as long as the underlying dynamics have not shifted, this could still prove transitory.
Stories are a useful frame for thinking through inflation dynamics and asking if they have changed.
The stylised facts of advanced economy inflation over the last five decades are clear:
Inflation was high and volatile in the 1970s, 1980s and, in some countries, into the early 1990s.
From the early 1990s until the financial crisis of 2007-09 inflation was low and stable. This period is often called the Great Moderation as a result.
From the crisis until the pandemic advanced economy inflation was generally subdued, aside from energy price related spikes that drove up the headline numbers.
But if the facts are relatively undisputed then the stories explaining those facts are still disputed.
I think one can tell two different stories about the taming of inflation that led to the Great Moderation.
The first story runs something like this and is rooted in structural changes in the shape of the macroeconomy, the supply side and changing political economy:
Beginning in the 1980s the structural bargaining power of labour was reduced a period of high unemployment following tight macro policy, by a breaking of trade union power and by the further liberalisation of the jobs market. The end of the cold war, the entry of China into the global economy and the globalisation of supply chains from the late 1980s into the 1990s supercharged these trends. The pool of labour available to Western capital almost doubled in the space of two decades. Meanwhile advanced economies became less energy-intensive. The result of less feedthrough from energy price spikes and lower goods prices due to globalisation was reduced headline inflation and lower volatility of inflation. Weaker labour bargaining power ruled out the kind of wage-price spirals which had bedevilled policymakers in the past and helped to keep services inflation low and stable.
Or one can tell a very different story, one rooted in inflation expectations and credibility. This one goes something like this:
Inflation was high and volatile in the past because macro-policy was ineffective. Monetary policy was too subject to political whims and fiscal dominance. Fiscal policy was often firmly set to manage a political business cycle (easier before elections and then overcompensating afterwards) rather than an economic one. Firms, workers and investors came to expect that policymakers would lack the resolve to tackle inflation so they set prices and wages ever higher. The solution was credible, independent central banks with a mandate to keep inflation low. These banks demonstrated their credibility by keeping policy tight to drive down inflation, even at a high cost in terms of joblessness. By the mid-1990s that hard-won credibility had helped to anchor inflation expectations. Now that firms, workers and investors had a clear view of the reaction function of central banks in the face of rising inflation they expected inflation to remain and low and stable and so set prices and wages on that basis.
Most central bankers it seems still prefer the second story – and who doesn’t like a story in which one is cast as the hero?
For an example, take a look at some recent work from some ECB economists on the role of globalisation in modern inflation dynamics, which drew upon a longer paper published as part of the ECB strategy review (and which is well worth taking the time to read).
The research notes that inflation has indeed moderated among all major advanced economies. But after discussing the profound deepening of global value chains and the intensification of trade flows over the 1990s and 2000s, the authors conclude:
The most intuitive explanation is that the concurrent inflation decline across advanced economies is due to (1) the monetary policy strategies adopted by the central banks of advanced economies over those years; (2) the wage concertation mechanisms consistent with those strategies (i.e. lower wage indexation); and (3) the consequent stabilisation of expectations.
Personally, I am not sure that is indeed the “most intuitive” explanation. “Macro policy got better everywhere at the same time” may indeed be the reason for the Great Moderation but ruling out “common factors changed the dynamics across the advanced economies” feels a step too far.
Of course both stories can have an element of truth in them. The stories are certainly not incompatible – macro policy can have become more effective at stabilising inflation alongside structural changes that made stabilising inflation easier.
My worry though is that central banks are so convinced of their own story that preserving their credibility becomes an end in and of itself. Global supply disruptions are going to hit output in the months ahead, fiscal policy is set to tighten sharply and the pandemic is not over. And yet still too many central bankers are focussed on fickle measures on inflation expectations and fretting about credibility.