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What if the inflation surge was temporary after all?




Throughout 2021, most major central banks have looked pretty inept as they defended the temporary hypothesis, namely that in increasingly strong inflation surge would be temporary and required no monetary policy action. One year later, they threw away the hypothesis and sought to reclaim the inflation fighter badge of honor by raising their interest rates at seemingly breakneck speed. They promised to keep at it until data would show that inflation is vanquished. Over the recent past, they have changed their tune. Feeling that inflation was going down to target, but not quite there, they are promising to keep interest rates high for long.


Well, it could be that they were right from the start, that inflation has been temporary. I am not being disingenuous. I am not claiming that, once inflation will be back to target, the surge will have been temporary. Rather, I am wondering whether inflation would not have gone back to target even without the generalized increases in interest rates, as the central banks initially asserted.


The immediate reason for reconsidering the temporary hypothesis is the rapid decline of inflation since the Summer when then interest rates reached a peak. Yet, even at their peak, when computed with contemporaneous inflation, real interest rates were still negative. Studies of successful disinflations by Alan Blinder and others suggest that real interest rates must become positive, and significantly so, for inflation to decline, and that happens with the famous “large and variable” lags. This is why makes the recent rapid disinflation under way a bit bizarre.


Of course, everything has been bizarre over the last few years, because unusual shocks have happened in short succession. Most observers ascribe the recent disinflation to falling oil and gas prices. This is what makes the original temporary hypothesis plausible. It asserted that the surge was mainly driven by a number of supply shocks, which could well be temporary. One of them was the increase in oil and gas prices. Another was the disruption of supply chains in the wake of the Covid pandemic. Yet another one was the increase in food prices. Under standard monetary policy principles, central banks should “see through” the inflationary impact of adverse supply shocks, even if they are not temporary in the sense that oil and gas prices do not have to return to their previous levels, they only have to stop rising. In such a situation, it is widely accepted that the best that central banks can do is to merely reiterate their commitment to price stability so that inflation expectations remain anchored to the unchanged inflation target.


I have been an early critic of the temporary hypothesis, for two reasons. First, because there were simultaneous demand shocks. Consumers enthusiastically dissaved the money that they had put aside during the acute pandemic phase while most governments were throwing around transfers and tax rebates in a bid to make sure that the post-pandemic economic recovery would not peter out prematurely. Second, soon after having been locked down, wage-earners were unlikely to graciously accept the drastic reductions in their purchasing powers wrought by the supply shocks. This was especially likely in view of the powerful recovery propelled by the demand shocks.


In the end, it may be that everyone was right. Without the demand shocks, the inflation surge would have been limited and temporary, which would not have required central banks to hike interest rates. What compelled central banks to intervene were the demand shocks, and they were late on that front. One can wonder why they did not foresee early on the strength of the private dissaving. One can also speculate why they did not factor in the expansionary fiscal policies, some of which predated the pandemic. My own interpretation is that the sort of models that central banks use, are particularly bad at understanding saving[1] and often claim that fiscal policy has limited effects. At the same time, wages have not yet caught up with inflation. They have been rising, slowly as they usually do, contributing to the much-feared price-wage spiral. As a result, inflation has gone further up and for longer than in the absence of demand shocks.


But the central banks are not out of the wood, yet, and they may be making another mistake. The rapid decline in inflation implies that monetary policy has turned contractionary only in recent months. Its effects will be felt in about one year. The current disinflation is less the result of the interest rate increases than of the end of the demand shocks as consumers stop dissaving and governments are ending their fiscal expansions. Now that the supply shocks fade away, it is may also be driven by the temporary hypothesis.


Inflation may not go much further down because the price-wage spiral is now under way, or because the demand shocks could prove to have long-lasting effects. In this case, the central banks will resume the process of hiking their interest rates. They regularly state that this option remains open.


Alternatively, if inflation returns to target in the coming months, the now-high real interest rates will quickly be seen as an overkill. In this case, the central banks will have to promptly cut their interest rates.


The central banks seem to have in mind an in-between scenario whereby the inflation rates decline a bit further but settle above target. They prepare opinions to keep interest rates at their current levels for quite some time, betting that positive real rates will complete the task. It may seem prudent to take an intermediate scenario, but that does not mean that it is the most plausible scenario.


This is a very uncomfortable situation as the three scenarios, taken together, imply that the interest rates may have to be raised, or cut, or kept high for long. At the heart of this difficulty is that economic forecasts have fallen in disrepute, forcing central banks to be data driven and to base their decisions on the current situation, not on what they confidently foresee. The reliance of high for long may seem prudent because high for long can be associated with both upside and downside risks.


This form of prudence, however, may be misplaced. Maybe central banks have been right in 2021 about the temporary scenario that they abruptly jettisoned in the face of incoming data. It badly hurt their credibility The same could happen again with high for long, even if they qualify their intentions with the existence of upside and downside risks.


A natural solution would be to accept the three contrasted scenarios as equally plausible. The central banks may dislike being seen as so deeply uncertain of the future, but this is the truth, and it is understandable. They may also fear that a deeply agnostic position would destabilize the financial markets, which always clamor for certainties. Even if market participants do not quite believe what the central banks say, a clear position has the merit, for them, to coalesce around any scenario. If the scenario eventually turns out to have been wrong, they may blame the central banks and retain their own credibility vis a vis their customers. For market participants, it is better to be collectively wrong than to be forced to make individual bets that might fail. This does not mean that central banks should provide markets with certainty when it does not exist. Managing uncertainty is the raison d’être of the financial markets, not of central banks.



[1] As I argued here, in DSGE models saving is explained by the Euler equation, one of “modern” macroeconomics acts of faith, which is systematically rejected in empirical tests.

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