Inflation? Really?

Mariano Torras Economic Theory, Finance, Future, General, Macroeconomics, Methodology/Statistics, Politics, Public policy/Wellbeing Leave a Comment

November 25, 2020

Last week my interest was aroused by an article written by Martin Wolf in the Financial Times (November 18th) in which he discusses a recent book by Charles Goodhart and Manoj Pradhan. In the article he provides a number of reasons why we might expect higher – possibly much higher – inflation in the coming years. And an article in today’s Wall Street Journal by David Harrison similarly suggests that, following successful introduction of a Covid-19 vaccine, widespread and pent-up demand could be released in short order provoking an inflation spike.

Meanwhile, there is no shortage of news on a renewed weakening in the labor market. Economists worry that such weakening is a direct consequence of people staying at home amid the pandemic, and that the present recovery is shakier than many realize. So, how, in light of this, can anyone be predicting inflation?

A glance at recent history would cast even greater doubt on inflation fears. Since the year 2000, the inflation rate has spent very little time above 3 percent (see Chart 1), has often been substantially lower over the past decade and has not exceeded 4 percent since 1991 – which is still very low compared to the 1970s.

Why then presume that a “post-Covid” recovery will cause it now? The argument presented by Harrison concerns the short run. Many industries, most notably travel-related ones like airlines and hotels, laid off tens of thousands of workers when the economic collapse happened in March. A recovery, if sufficiently abrupt, might result in what we call “demand pull” inflation (see Chart 2), which is what happens when a demand surge drives prices higher as understaffed suppliers struggle to keep up. There is indeed no reason not to expect a significant uptick in travel and other forms of spending if infection rates were to drop dramatically.

The fact that there might be signs of renewed weakening in the wake of a recent Covid spike nationwide is almost beside the point. The demand-pull argument is relatively sound in a “sooner or later” sense. But its limitation is in its neglect of the long run.

Economist William Phillips in 1958 published a paper in Economica, introducing what later became known as the Phillips curve into our understanding of inflation. In a nutshell, his argument was that there was an inverse relationship between inflation and unemployment. Or more specifically, when the economy was doing well, the unemployment rate would be low and the inflation rate high; and the opposite when the economy was in recession. But Milton Friedman and others have been highly critical of the Phillips curve, claiming that it only applies in the short run, if indeed at all.

The observation segues nicely into the Martin Wolf piece which, in contrast, considers the long run. The authors Wolf cites claim that we are approaching the end of an era or “regime.” Since around 1980, we have experienced relatively low inflation for two main reasons. First, the workforce both in the United States and worldwide has grown faster over the past 40 years than the population. With workers relatively abundant, wages stay low, hence inflation does too. Partly as a consequence of persistently low inflation, inequality has increased, since concentrated wealth does not erode in value as rapidly when inflation is low (the flip side is that due to the competitive forces unleashed by globalization, global inequality has gone down). And as a partial consequence of increased inequality, indebtedness has increased substantially.

It is this era that ostensibly is in its death throes. The coming period will see less competition as globalization recedes (it is already happening) and industries become progressively concentrated. Populations the world over will continue aging (no doubt here), inverting the earlier problem: Now, a relative labor scarcity will increase worker bargaining power. Presumably then, wages and prices will be driven up. And all this will decidedly not be a short-term phenomenon.

Could it really be that simple? Personally, I find the argument somewhat compelling. The problem is that economics is messy (have I said this before?); it is easy to isolate a few key determinants and develop a theory around them. I agree that demographic shifts are likely to bring major economic changes. But despite undeniable long run inflationary pressures, I believe that the specter of its opposite – deflation – is likely to keep them at bay.

Key lending rates have been at anemic levels for most of the past decade. While they have fueled inequality-increasing speculation, real investment has not been taking the bait, contrary to basic economic theory which suggests that low rates are an inducement to borrow for purposes of business expansion. Mergers have instead been the norm. Recent experience indeed has all the hallmarks of secular stagnation.

The Federal Reserve gets it. Its new (August) framework on inflation targeting clearly signifies that after decades of ill-founded fears of inflation, it has finally recognized that it was little more than a bugbear. And as my co-author and I noted in a recent article, if there has been any inflation it has been of asset, as opposed to goods prices. In a “double movement” of sorts, asset inflation intensifies inequality which, as middle America stagnates, keeps goods inflation very low. And it in turn justifies keeping rates low.

There does not appear to be any sign that the unsustainable borrowing binge that we’ve seen over the past 25 years is reversing. Yet it is true that populations everywhere are aging inexorably. And we know that older people borrow much less, on average, than younger people. The tension between the economy’s addiction to debt and the coming demographically induced collapse in demand for it points to a major rupture at some point. But when it will happen and what form it will take is anyone’s guess.

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