‘Danger that we think too quickly that inflation has been controlled’

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We paid a high price for controlling inflation in the 1980s. The then Fed boss, Paul Volcker, spearheaded the fight at the time. Inflation was overcome with sky-high interest rates. Unfortunately, this was on penalty of a deep recession, formally two in a row in the US, and high unemployment.

Because inflation took us by surprise in 2021, wage increases lagged behind, causing a significant loss of purchasing power. (ANP / Jeffrey Groeneweg)

When inflation unexpectedly rose sharply in 2021 and central banks resumed the fight after some delay, a similar scenario was expected. Official interest rates were increased by unprecedented steps and inflation started to decline from the autumn of 2022, helped by lower energy prices. This is how the script from forty years ago was followed. There was one big difference. There has been no deep recession, at least so far.

Find the differences with then

This raises the question of whether we will win the battle against inflation without paying a high price in terms of unemployment. And if so, what explains the difference compared to forty years ago?

Also read | Lagarde stuns with answer, ‘what does the ECB want?’

In the press conference after the Fed’s last policy meeting, Powell said some interesting things about this and ECB director Isabel Schnabel devoted an interesting speech to it last week.

‘Are we going to win the battle against inflation without paying a high price?’

Powell identifies two different factors that have brought inflation down. Naturally, the tighter monetary policy has slowed economic growth somewhat and also contributed to dampening inflation expectations. In addition, the disappearance of logistical disruptions has played an important role. The latter is a significant difference from forty years ago.

Also read | ‘Degrowth economy will be a catastrophe’

When it comes to logistics disruptions, we should think of the lockdowns during the pandemic, which prevented many people from working, resulting in a reduction in production capacity. However, government support measures maintained demand for goods. This created an imbalance between supply and demand. In addition, international transportation costs exploded and supply problems arose in supply chains.

So these were the temporary factors that central banks initially thought would disappear quickly. Unfortunately, that was quite disappointing, after which a more comprehensive inflation process started. But, as Powell indicated, these logistical disruptions have now been resolved, resulting in production capacity being restored, the imbalance between supply and demand having disappeared and various costs having been normalized again.

Celebrate prematurely

We must realize that the downward pressure on inflation resulting from the resolution of the logistical disruptions will be temporary, just like the previous temporary nature of their inflationary effect. However, there is a danger that we may think too quickly that inflation has been contained. A recent IMF study calls these ‘premature celebrations’.

‘There is a danger that we think too quickly that inflation has been contained’

Schnabel speaks of the final steps that weigh most heavily in the fight against inflation. Powell fears that achieving the inflation target will ultimately cause the necessary pain of rising unemployment. Once these temporary inflation-reducing effects wear off, inflation is likely to rebound.

Also read | If recession remains mild, ‘long period of stagnation will follow’

It is clear that the sudden increase in inflation from mid-2021 has not been caused by wage increases. In fact, because inflation took us by surprise, wage increases lagged behind, causing a significant loss of purchasing power. A catch-up process is now underway. And although this is completely logical and defensible, it also carries the risk that inflation will exceed the target of central banks in the medium term.

After some time, wage increases should reach a level consistent with two percent inflation. It is impossible to predict whether unemployment will first have to rise and, in particular, how strong that increase in unemployment would have to be. It’s not impossible, but I suspect a completely painless victory over inflation is unlikely. It would, as the title of this column indicates, be a minor miracle. Do you believe in miracles?

Because inflation took us by surprise in 2021, wage increases lagged behind, causing a significant loss of purchasing power.
Because inflation took us by surprise in 2021, wage increases lagged behind, causing a significant loss of purchasing power. (ANP / Jeffrey Groeneweg)

When inflation unexpectedly rose sharply in 2021 and central banks resumed the fight after some delay, a similar scenario was expected. Official interest rates were increased by unprecedented steps and inflation started to decline from the autumn of 2022, helped by lower energy prices. This is how the script from forty years ago was followed. There was one big difference. There has been no deep recession, at least so far.

Find the differences with then

This raises the question of whether we will win the battle against inflation without paying a high price in terms of unemployment. And if so, what explains the difference compared to forty years ago?

Also read | Lagarde stuns with answer, ‘what does the ECB want?’

In the press conference after the Fed’s last policy meeting, Powell said some interesting things about this and ECB director Isabel Schnabel devoted an interesting speech to it last week.

‘Are we going to win the battle against inflation without paying a high price?’

Powell identifies two different factors that have brought inflation down. Naturally, the tighter monetary policy has slowed economic growth somewhat and also contributed to dampening inflation expectations. In addition, the disappearance of logistical disruptions has played an important role. The latter is a significant difference from forty years ago.

Also read | ‘Degrowth economy will be a catastrophe’

When it comes to logistics disruptions, we should think of the lockdowns during the pandemic, which prevented many people from working, resulting in a reduction in production capacity. However, government support measures maintained demand for goods. This created an imbalance between supply and demand. In addition, international transportation costs exploded and supply problems arose in supply chains.

So these were the temporary factors that central banks initially thought would disappear quickly. Unfortunately, that was quite disappointing, after which a more comprehensive inflation process started. But, as Powell indicated, these logistical disruptions have now been resolved, resulting in production capacity being restored, the imbalance between supply and demand having disappeared and various costs having been normalized again.

Celebrate prematurely

We must realize that the downward pressure on inflation resulting from the resolution of the logistical disruptions will be temporary, just like the previous temporary nature of their inflationary effect. However, there is a danger that we may think too quickly that inflation has been contained. A recent IMF study calls these ‘premature celebrations’.

‘There is a danger that we think too quickly that inflation has been contained’

Schnabel speaks of the final steps that weigh most heavily in the fight against inflation. Powell fears that achieving the inflation target will ultimately cause the necessary pain of rising unemployment. Once these temporary inflation-reducing effects wear off, inflation is likely to rebound.

Also read | If recession remains mild, ‘long period of stagnation will follow’

It is clear that the sudden increase in inflation from mid-2021 has not been caused by wage increases. In fact, because inflation took us by surprise, wage increases lagged behind, causing a significant loss of purchasing power. A catch-up process is now underway. And although this is completely logical and defensible, it also carries the risk that inflation will exceed the target of central banks in the medium term.

After some time, wage increases should reach a level consistent with two percent inflation. It is impossible to predict whether unemployment will first have to rise and, in particular, how strong that increase in unemployment would have to be. It’s not impossible, but I suspect a completely painless victory over inflation is unlikely. It would, as the title of this column indicates, be a minor miracle. Do you believe in miracles?

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