What kind of pain do you prefer?
“I aim to bring inflation back down to target such that workers can enjoy real wage gains from their labour”. Fine words from Catherine Mann, a member of the Bank of England’s (BoE) Monetary Policy Committee, which sets UK interest rates.
But, according to calculations by Bloomberg, if she wants to bring inflation back to its targeted 2% this year, the BoE would need to raise interest rates to such a level that 1.2 million people would be made unemployed.
Even if the nominally independent BoE had the appetite for such aggressive action, it would be politically suicidal for the government. The BoE has just doubled interest rates again, to 0.5% — and now forecasts inflation will reach 7.25% in April. The British public is already bracing itself for a rise in National Insurance (which employers will also have to pay and are already threatening to push up prices to cover the cost) and household energy costs are likely to rise by 50% in April. Half of gas suppliers in the UK market have already collapsed, as they are forced to pay high wholesale prices but are limited as to what they can charge. Many people in the UK are facing a ‘heat or eat’ dilemma ; pushing people out of jobs after two years of sporadic pandemic lockdowns would be devastating. But so will inflation if it’s not curtailed.
The BoE more than doubled the UK’s interest rate in December, pushing it from 0.1% to 0.25%, as the headline inflation rate rose to an annualised 5.1% (it’s now 5.4%, the highest consumer price index rate since May 1992). Back in the mists of time the BoE had a target of 2% for inflation, but inflation has now clearly escaped the bank’s control. Not only that. Inflation could be “stronger than what is generally expected” according to Nicolai Tangen, the CEO of Norway’s $1.3 trillion sovereign wealth fund. The same opinion is held by economists at BlackRock, the world’s biggest asset manager.
BlackRock’s thinkers believe that we’re “in a new market regime”, by which they mean that the current inflation could prove to be ‘stickier’ than we hope. Alex Brazier — who left his post as executive director of financial stability, strategy and risk at the BoE early in 2021 and later joined BlackRock — summed up for Bloomberg this week the dilemma facing the US Federal Reserve, a dilemma faced by all central bankers: “The Fed has a hard choice — live with inflation or destroy the overall level of demand in order to get rid of supply constraint inflation… The Fed would have to raise rates so high it would create a recession big enough to result in a double-digit unemployment rate”.
In the US, the consumer price index rose to an annualised 7% last year, the highest since June 1982, the year that the movie E.T. was released and Argentina and Britain went to war in the south Atlantic.
Push up interest rates and conventional economics says that might curb inflation, but higher interest rates could slam the brakes on the economic recovery. They would also ripple around the world and hurt developing countries. That’s because many poorer countries have borrowed in US Dollars, exposing them to two risks — bigger interest payments if rates rise, and a weakening of their local currency as the Dollar strengthens (as it will on a rates rise). In the Financial Times, Martin Wolf observed: “Losing control over inflation is politically and economically damaging: restoring control usually requires a deep recession…the Fed continues to ladle out the punch, even though the party is turning into an orgy”.
If you are a citizen of an emerging economy, or a member of a developed one, the big question right now is — what kind of pain do you prefer?
Paul Volcker, chairman of the US Federal Reserve between 1979 and 1987, said: “It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less… if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy”.
The creation of fiat money — banknotes and coins deemed to be legal tender — has exploded during the two years (and counting) of the Covid-19 (and its variants) pandemic. The latest newsletter from the US investment management firm Bridgewater Associates says US monetary and fiscal policies have provided a “massive adrenaline shot of money and credit that is now producing a self-reinforcing cycle of high nominal spending and income growth that is outpacing supply, producing inflation”. From the start of the pandemic to October 2021 US household wealth increased by $32 trillion, although some did rather better than others.
For some, this money creation is the source of inflation. According to Mihai Macovei, writing on the Mises Institute website, “the current surge in inflation… is primarily due to soaring consumer demand fuelled by excessive growth stimuli and monetary creation… We are witnessing a consumption boom and persistent distortions in the structure of production, all bearing a striking resemblance to the boom that preceded the Great Recession”. Others take a much more relaxed view and point out that the Fed printed just $185.7 billion in 2020.
But this is misleading. Printing physical notes is not really how the Fed has created trillions of Dollars during the pandemic years. Instead, the US Treasury digitally creates bonds, which are then bought by a variety of domestic and foreign investors, including the Fed, adding to the US national debt, which is now very close to $30 trillion, the highest ever. While the US does not physically create super tanker amounts of fiat money, it certainly facilitates the lending of new money to the federal government. This is how President Joe Biden could ‘afford’ his multi-trillion Dollar ‘stimulus’ programmes; it’s borrowed.
The US Federal Reserve and the US Treasury Secretary, Janet Yellen, spent much of last year trying to persuade us that inflation was ‘transitory’. That narrative had bitten the dust by the end of last year. Meanwhile the US debt rose to levels unseen since the Second World War, and is still climbing. Inflation has only one major benefit — it makes interest payments on that debt mountain less onerous.
The Fed has a dual mandate — to achieve price stability and maximum employment. The US labour market is now very tight; the prime-age non-employment rate, unemployment rate, number of unemployed people per vacancy and quit rate are all stronger than the 2001–2018 average.
Yet real (i.e. inflation-adjusted) earnings in the US are around 4% below trend. Prices in the UK and on the other side of the Atlantic are generally rising faster than wages. The fear of governments and central banks is a return to the 1970s, when the phrase “wage-price spiral” became familiar.
One big difference between the 1970s and today is that the power of trades unions is not what it was. Workers do not have the same organised ‘muscle’ to enforce demands for higher wages. According to the website inequality.org, by last October America’s billionaires’ wealth had surged by 70% during the pandemic; the 745 billionaires held at that time $5 trillion, compared to $3 trillion held by the bottom 50% of US households. In the months before mid-term elections in November, President Joe Biden can ill afford inflation to continue unchecked — but equally he cannot risk throwing the fragile post-Covid economic recovery under the bus. As BlackRock argues, the risk is high: “policy cannot stabilize both inflation and growth at the same time: it has to choose between them. In other words, central banks have to either accept higher inflation or destroy demand to rein in inflation. Given the historical relationship between unemployment and inflation, if central banks had sought to keep inflation close to 2% amid the supply constraints experienced in the restart, this would likely have meant needing to drive the unemployment rate up to nearly double digits”. But doing nothing is not an option; watch this space.