What Cost Disinflation?
The debate over the causes of the 2021 worldwide surge in inflation has been superseded by events without having furnished a consensual conclusion. Many economists and policymakers still hold that the key determinants are supply-side distortions, shortages generated by the pandemic lockdowns, which were accentuated by Russia’s war against Ukraine, particularly in energy markets. Others insist that it is essentially a demand-side phenomenon, generated by a miscalculation in monetary policy: prolonged expansionary credit policies, put in place in the decade following the Great Recession, were too keenly extended and in many cases supplemented by generous fiscal stimulus measures with the onset of the pandemic, leading to increased money balances chasing too few goods once vaccination against the virus – which can be viewed as a positive demand shock – was available and quarantine measures were gradually lifted, while the war in Ukraine played only a secondary role, primarily through hoarding, congestion and panic in oil and gas markets often dependent on sanctions-hit Russian infrastructure and supply.
Many economists and policymakers still hold that the key determinants are supply-side distortions, shortages generated by the pandemic lockdowns, which were accentuated by Russia’s war against Ukraine, particularly in energy markets. Others insist that it is essentially a demand-side phenomenon, generated by a miscalculation in monetary policy.
Why is Eastern Europe the hardest hit?
Anyway, what’s done is done. The issue of the day has changed. Inflation has surpassed 8% in the major advanced economies of Eurozone and the United States of America, and even rose modestly in deflationary trapped Japan, while it has surpassed 15% in the Eastern European Union countries not sharing the single currency. At first glance, the latter seemed to have born the blunt of the panic and price increases in energy markets, at least compared to their Western-European neighbours, but this is hardly the case, because following previous gas crises generated by Russia most of these countries took active measures to reduce their dependence on Russian energy (even though not all of them came to fruition) while countries such as Germany intentionally or unintentionally took steps to increase their energy dependence on Russia. The higher-than-Eurozone inflation rate in the Eastern EU countries, more than twice as high on average, therefore reflects pre-pandemic strained fiscal deficits as well as the low credibility of their central banks when it comes to combating inflation rather than a higher exposure to sharply increased energy costs. In any case, everyone agrees that inflation is too high and that inflation should be reduced. But at what cost?
The debate over the determinants of the inflationary surge has now morphed into a debate over how best to tame it. Thus, the US Federal Reserve led by Jerome Powell has taken decisive steps to increase the bank’s reference interest rate, known as the federal funds rate, bringing it back to its January 2008 level from between 0-0.25% after six consecutives increases, four of which of three quarters of a percentage, while the European Central Bank led by Christine Lagarde – prioritizing debt stability and schemes to prevent credit risk divergence in the euro debt market – lags a bit behind, with only three main rate increases, of which only two of 0.75%. However, the independent central banks of Central and Eastern European countries were the first to recognize the danger of out-of-control-inflation – and their vulnerability to it! – and began to raise their interest rate benchmarks as early as summer 2021 (the first group composed of the Czech Republic and Hungary) and fall 2021 (the second group composed of Romania and Poland), that is a quarter to two quarters or even two to three quarters earlier than the Fed and the ECB respectively.
The higher-than-Eurozone inflation rate in the Eastern EU countries, more than twice as high on average, therefore reflects pre-pandemic strained fiscal deficits as well as the low credibility of their central banks when it comes to combating inflation rather than a higher exposure to sharply increased energy costs.
This rapid pace of monetary tightening in the United States, and Central and Eastern Europe, has triggered growing calls for these central banks to moderate their interest rate hikes. The critics fear that a too fast-paced monetary tightening schedule will throw these economies into recession and argue that a slower-paced monetary schedule can avoid this scenario while also putting a break on inflation. But can central banks have it both ways?
The historical experience in the matter is rather unfavourable. The pre and post-Volker era monetary policy constitutes a paradigm in this regard. The previous Federal Reserves Chairmen and US Presidents allowed inflation to soar from only 1% in 1965 to 14% in 1980, when Paul Volker became governor of the American central bank. This unprecedented rise in the US price level over the course of a decade and a half went hand in hand with a gradual deterioration of economic growth and increased unemployment. The rise in prices was halted only when the federal funds rate was raised to 14.6%, a little over the rate of growth of the price level, which triggered a brief recession before the economy recovered on a disinflationary path. The lesson learned then was that, once inflation expectations are left unchecked for too long and they go haywire, it takes drastic decisions to restore confidence in a sound economy. Nothing short of interest rates higher than the inflation rate, an earthquake for financial markets, could do it.
Evidently, the current inflationary predicament monetary policymakers face is not the same as the one Paul Volker faced 43 years ago. For starters, prices have only increased for about a year and a half, not for 15 years, real GDP is still growing and the unemployment rate is falling, although at a lower rate. Secondly, the measures of expected inflation developed in the aftermath of the 1980 Great Disinflation are becoming unreliable. The 5 years TIPS Break Even Rate, a highly observed measure of medium term inflation for the US, currently indicates an expected inflation of 2.67% instead of the 8.20% actual inflation, and the measure doesn’t get any better if one considers, in order to avoid optical illusions, only the rate of change instead of the level since January 2021 when actual inflation took off: 39 pp increase in expected inflation vs 485 pp actual! Nevertheless, the moral of the Volker story still goes almost unchallenged among economists, and it comes with a warning: the longer inflation is left unchecked, the harder will be for central banks to contain it – in other words, a time of inflation reckoning will come, postponing it will only make things worse.
The growing calls for moderation in the pace of central banks’ rate-hiking schedules haven’t fallen on deaf ears. Thus, Jerome Powell, The Federal Reserve Chairman and the most influential of the “hawkish” central bank governors, ruled out another 0.75 federal funds rate hike. This doesn’t seem to be the result of short-term political pressure over the Fed, say, connected to the US Midterm elections, because the Board of Governors of the Czech National Bank (CNB), for instance, has left its benchmark interest rate unchanged at 7% for the last three meetings, despite an inflation rate exceeding 18% forecast to reach 20% by the year’s end.
Last but not least, the National Bank of Romania (BNR) seems to have reduced the magnitude of its interest rate hikes, from 0.75% in July and August to only 0.5% in its last monetary policy meeting on November 9th, after a pause in September and a full 1% hike around the middle of May, which brings the reference interest rate at 6.5% while the inflation rate stands at 15.88%. In all cases, concerns related to the slowing rate of economic growth are suggested as reasons for slowing the pace of monetary tightening.
The critics fear that a too fast-paced monetary tightening schedule will throw these economies into recession and argue that a slower-paced monetary schedule can avoid this scenario while also putting a break on inflation.
The latter decision is worth a closer look, because it might provide insight into the thinking of a broader group of central bank governors in the region and even outside it. Although nowhere in its minutes does BNR’s Board say it has irreversibly decided to reduce the size of its future reference interest rate hikes by 25 bps, the inflation forecast released after its monetary policy meeting indicates that the Board members think the inflation rate has more or less reached its peak, that it is now stable, and that it will begin to go down beginning next year, although only in 2024 the Romanian inflation rate will return to single digits and slowly approach its 2.5% target, without actually reaching it by the forecasted period’s end (previously, BNR estimated that the inflation rate will fall by the year’s end and actually enter its 2.5% target in Q2 2024). Whence, or so it appears, the reason behind the tacit decision to reduce the magnitude of new interest rates increases: a stabilised and decreasing inflation rate allows for a lighter interest rate increase schedule, according to BNR’s own forecast.
The forecast is here the key to the policy decision puzzle. Absent reliable measures of expected inflation, the BNR – like other central banks, the Fed included – is in fact targeting its own inflation forecast. In other words, the Bank’s reaction function – also known as a policy rule, or just a policy decision – is a function of its own forecast. Thus, the Bank’s forecasters expect the supply-side or exogenous component of inflation to ease, following the relative fall in energy prices and the implementation of compensation schemes or consumer subsidies. This in turn allows the Bank’s Board Members to reduce the pace or the magnitude of rate hikes necessary to achieve the inflation target – or, stated differently, this gives the Board Members room to extend the time frame necessary to bring the inflation rate into the targeted rage. Hopefully, lower-than-otherwise interest rates will allow the economy to remain afloat despite strong price pressures until inflation dissipates and growth gains the upper hand...
The moral of the Volker story still goes almost unchallenged among economists, and it comes with a warning: the longer inflation is left unchecked, the harder will be for central banks to contain it.
The Volker Fed critics have long held that the US central bank’s 1980 decision to hike the federal funds in a very short time to a level above inflation, instead of spacing the rate hike over a longer timeframe, deliberately gave rise to an unnecessary recession, while its defenders maintain that only an unanticipated monetary policy shock was able to shift expectations and lift the economy out of stagflation. It seems that the 1980 monetary policy critics now have the chance to prove themselves once more while the economy is still in relatively good shape, but it remains to be seen if they can tame the proverbial inflation tiger before it bites its tail.
Photo source: pxhere.com.