Philip Cross: The government is driving inflation
Governments must work to eliminate their deficits or the upward pressure on interest rates will intensify
Inflation is proving to be more than transitory, reaching an 18-year high of 4.7 per cent last month. Government-created distortions of personal incomes, savings and labour market choices are helping fuel it. These distortions also make inflation harder to forecast, although economists have long struggled to develop a viable theory that forecasts inflation. As a result, many central banks have been slow to react to the price rises.
At a fundamental level, inflation reflects our collective inability to agree on how to pay for the massive debts incurred during the pandemic. Policy-makers assumed the pandemic’s major effect was greater for demand than supply. The disruption to supply surprised the Bank of Canada, which in summer 2020 predicted «much of the initial decline in supply is likely to be relatively short-lived.» Central bankers are now hedging their forecasts, however. « The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation».
The government’s most striking distortion was to provide so much emergency income support that personal disposable incomes actually rose in a recession. Earned income fell sharply but massive government support more than made up the difference. The increases in incomes and savings show that much government aid was not needed, especially during the slow shift from economy-wide stimulus to targeting specific sectors. The government response also distorted the labour market, resulting in the unusual pattern of high unemployment combined with high job vacancies.
Accelerating inflation underscores how economists have long struggled to understand price dynamics. Higher inflation was unforeseen because, as former Fed Governor Daniel Tarullo observed, economists have no reliable theory of inflation. The blurred relationship between unemployment and inflation has led some economists to relabel it the «Phillips Cloud». Nor do price expectations reliably anticipate inflation.
Tarullo advises central banks to watch wages and prices and to start hiking interest rates once actual inflation rises. So far, central banks have not followed this advice. Harvard’s Kenneth Rogoff argues that economists struggle to understand inflation dynamics because «controlling long-run inflation is fundamentally a political-economy challenge, not a technocratic one.» In the 1960s and 1970s inflation originated in the soaring costs of the Vietnam War and Great Society social programs, which in the absence of tax hikes raised government deficits and put pressure on the Fed to keep monetary policy. More broadly, inflation is symptomatic of an inability to agree on who will pay for high government debts.
We are acting as if the pandemic’s enormous cost can be off-loaded to a few wealthy individuals and large firms. In 2003, Nobel laureate Robert Lucas claimed macroeconomics had succeeded because «its central problem of depression prevention has been solved.» The world did dodge depression in both 2008 and 2020. The Bank of Canada eventually will curb inflation. But the longer it delays, the higher rates will have to rise, aggravating the pain of soaring debts during the pandemic.
Source: Philip Cross | Financial Post