Goodhart: "We have no general theory of inflation"

Professor Charles Goodhart, a Pacemaker.Global Advisor, professor emeritus at the LSE and former member of the Bank of England’s monetary policy committee, made a rather remarkable statement at the ECB Forum on Central Banking 2021 last month: the world at the moment is in a really a rather extraordinary state because we have no general theory of inflation (Charles starts at 16:00 minutes). Given that all governments, corporations and consumers everywhere are experiencing the reality of accelerating inflation, and central banks in both smaller OECD and EMDE economies are tightening policy to curb inflation, does it matter that we don't know what causes inflation?

Charles points out that the Friedman monetarist theory that inflation is always driven by the quantity of money and the Keynesian theory that inflation comes from tight labour markets driving up wage costs are both unsupported when weighed against evidence. The Powell Federal Reserve and others have preferred to explain inflation as driven by 'expectations'. Charles doubts that this 'bootstrap theory of expectations' is any better supported by evidence, and draws attention to the Jeremy Rudd paper we highlighted two weeks ago in Inflation Expectations Aren't What They Used To Be.

If inflation isn't derived from the quantity of money, from wages, or from expectations, will raising domestic interest rates prove an effective measure against inflation? In small, open economies the biggest impact of higher rates may be through foreign exchange markets as higher rate economies may be more attractive to external investors. Higher rates will stabilise inward investment, credit in USD and EUR, and exchange rate volatility, and so may effectively curb imported USD and EUR inflation. But higher domestic rates can squeeze corporate and consumer spending, and so be a drag on economic recovery and future growth. And rate rises that lead to falls in mortgage lending and real estate prices in highly leveraged economies can put domestic banks and lending under stress.

Avinash Persaud has suggested that central bankers in small, open economies should isolate imported inflation as an element of domestic observed inflation. But if raising domestic rates helps sustain the currency in foreign exchange markets, and sustain domestic access to USD and EUR credit, then maybe raising rates is the most effective way to curb imported USD and EUR inflation. Staying ahead of the inflation curve may be important to stability when rates begin to rise for USD and EUR, as they are already rising in credit markets and bank lending to the private sector.

When he was Chairman of the Board of Governors of the Federal Reserve System, Alan Greenspan's favourite indicator of rising inflation ahead was PMI supplier delivery times. When purchasing managers start to worry that their supply chains are under pressure, then costs will rise and inflation will rise. As supply chain disruptions are surging, perhaps Greenspan's views merit consideration by this generation of central bankers. Looking at the world today, there is good reason for concern, especially in US, UK and Eurozone.

IHS Markit's PMI Supplier delivery times data were sending worrying signals from Q4 2020 that inflation might be rising into 2021.


Chris Williamson, Chief Business Economist, IHS Markit, lays out the policy dilemma for central banks in his September 21 newsletter on PMIs:

Prices rise across the board
A common thread in the September flash surveys was the feeding through of supply shortages, and in the cases of the US and UK, labour supply issues, in turn driving up prices. Average input costs rose at accelerated rates in all four major developed economies, rising close to almost regain recent all-time survey highs in the US and UK and climbing to a 21-year high in the eurozone. Even in Japan, input cost inflation accelerated to the fastest for 13 years.

Policy headache
The divergence between the PMI signals of slower economic growth and steepening price pressures presents a dilemma for policymakers in the major central banks. While the price gauges fuel calls for policy accommodation to be scaled back, the deteriorating output momentum calls for caution.

Part of the dilemma is the assessment of the extent to which the current slowdown in output is a function of weaker demand or supply issues. Certainly the latter are causing some of the slowdown (for example, if an auto maker cannot produce cars due to a shortage of semiconductors, they are not going to be buying as many other inputs such as tyres, steel etc, and also not buying in as many industrial services). But it is unclear just how much of the slowdown reflects a softening of demand after the initial surge in spending as economies opened up once vaccine roll-outs reached successful stages. Let's not forget that the global economy looked far from healthy in the lead up to the pandemic. The global PMI came close to a decade-low back in October 2019, albeit picking up slightly as we moved into 2020.
For hawks, however, the additional concern is that it is also not clear how long the supply constraints will persist for. Each month of deteriorating supply not only adds to producer price pressures, but also adds to the likelihood of these higher prices feeding through to higher wages. Any material pick-up in such second-round inflation effects could mean inflation stays higher than central banks are currently envisaging.
The coming months of PMI data should therefore prove crucial in illuminating some of these trends, and hopefully pave a clearer path for policy.

I will add that the financialised economy is now much larger relative to the real economy in 2021, and levels of global debt and leverage are at record highs too. A decade of accommodative policies, QE and near-ZIRP or even negative rates have increased systemic leverage beyond anything conceived in earlier decades, theories, or models, and stimulus to counter the pandemic shock has grown leverage in both the financial economy and the real economy even further. Central banks in the 21st century have consistently chosen expansionary policies to support asset prices, debt growth, and larger fiscal deficits in the name of financial stability (not part of any central bank mandate in the 20th century).

Cost-push inflation is hard to fight as central banks can't print oil, gas, coal, microchips, freighters, or any of the other factors driving supply chain disruptions. Demand destruction is the normal route to curb inflation, through passing higher interest rates onto borrowers and making some segment of the economy obsolete and some of the workforce unemployed. With many economies now heavily financialised and leveraged and near universal real estate bubbles, any demand destruction poses a difficult trade-off, hence the refrains of 'transitory' where cost-push inflation risks are running hottest: US, UK and Eurozone.

Those of us who remember the 1970s and 1980s fear that inflation often quickly feeds through to political instability, labour strikes, civil unrest, borrower distress, credit defaults, and other real-world spillovers that can make inflation forecasting, economic forecasting, and financial stability interventions even more problematic.

We have the reality of rising global inflation. Charles Goodhart reminds us that we need to work on the theory of inflation and policy implications from new perspectives.

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