Last week we wrote about the shift in monetary policy over recent years from preemptively attacking the first signs of inflation to reacting to inflation once it is established in the data. The shift in policy thinking by central banks came in the latter years of the long period between the early 1990s and late 2010s when strong disinflationary pressures ruled. Some of the key factors contributing to disinflation were globalisation of production and flow of labour, technological development, demographics and through much of the period an emphasis on budget discipline by governments.
These long-term disinflationary forces kept inflation on a downward trend. There were periods when inflation rekindled during upswings in economic activity but central banks were quick to move and often on the earliest signs that inflation was rising. Inflation stayed low and on underlying measures often undershot their inflation targets for years.
It was against this backdrop of constantly undershooting inflation targets that central bank started to change policy focus. Keeping inflation too low meant that central banks were risking cutting off upswings in economic activity too early and not allowing economies to reach full employment.
The catalyst for central banks to start thinking about changing their inflation fighting spots was the 2008-09 global financial crisis. Policymakers faced urgent need to fight deep recession and deflation. Governments responded by lifting spending but the fiscal largesse was comparatively short-lived in many cases, especially in Europe where fiscal austerity was soon demanded by the EU to try and bring member budgets and government borrowings down to meet the strictures of operating in a common currency area.
Much of the policy burden to counter the recessionary effects of the global financial crisis fell on the central banks. With deflation rather than inflation in prospect central banks opened their policy stops including reducing official interest rates to zero and less and using their balance sheets to buy assets and pump banking sector liquidity. The recovery after the global financial crisis was a slow and patchy for many countries reliant on ultra-loose monetary policy with little support and some cases active hindrance from fiscal policy. China was an exception with by far the strongest fiscal spending program after the global financial crisis helping to promote strong economic growth in the 2010s.
US economic recovery post global financial crisis was also better than most prompting a still pre-emptive inflation fighting Fed mid 2010s to start slowly reducing monetary support. Faltering US economic growth in the wake and underlying inflation travelling sub 2% target sowed the seeds of the Fed’s rethink from pre-emption to reaction on inflation.
In early 2020, the global pandemic and its various versions of lockdown around the world caused deep recessions and briefly heightened deflation risk. Central banks responded promptly reducing already very low interest rates where they could and expanding their balance sheets. This time, however, they were also backed by Governments abandoning budget constraints and increasing spending on the largest scale since World War II. Moreover, it was high octane spending putting money directly into households and businesses.
Many governments changed their spots during the pandemic shifting from being fiscal puritans to profligates. The US government is in the process of delivering massive multi-year new spending on physical and social infrastructure even though the US economy is growing strongly and with annual CPI inflation now running above 6% y-o-y. The Australian government including the State governments are spending up with little regard to the impact on budget bottom lines. Fiscal policy priorities have changed through the pandemic. The need for spending support to sustain stronger economic growth now trumps the need to contain growth in government borrowing.
Another important change during the pandemic is the denting of globalisation. Supply shortages of goods in high demand have forced many countries to consider security of supply and think about rebasing some production back onshore rather rely on supplies from overseas. The easy movement of labour around the world pre-pandemic virtually halted at times during the pandemic and may face longer-term post-pandemic impediments. Globalisation cannot be relied on to be a disinflationary force going forward.
The supply chain problems responsible for much of the immediate upward pressure on prices around the world are also proving slow to dissipate and on the latest factory gate (final stage producer price) readings in major supply economies are still worsening. October US producer prices were up 6.8% y-o-y; China’s producer prices were up 13.5% y-o-y; and September producer prices in Europe were up 16.0% y-o-y. In a country such as Australia, still heavily reliant on imports of manufactured goods, these are the high price changes sitting in the pipeline.
The RBA is among central banks that have taken to heart the power of the disinflationary forces that were indisputably in play for a long period from the early 1990s. The RBA believes it can actively promote higher inflation without fear of it getting out of control because the labour market is not tight enough to generate the order of wage growth that in the disinflationary past would have been consistent with consistently higher inflation.
The problem is that key disinflationary forces from the past may have lost much of their power. Globalisation is threatening to turn to de-globalisation. Fiscal policy is primed to support already strong spending in a world struggling to resolve supply constraints. Central banks maintaining ultra-easy monetary conditions in this new (rather back to the 1980s) world of non-wage growth related inflation threat is the equivalent of poking a stick in an inflation hornet’s nest.
The inevitable sting comes from persistently higher than expected inflation readings prompting higher than expected wage increases down the track and even higher inflation. Wages lag in this new price/ wage spiral and if central banks wait for higher wages before hiking rates, they risk a phase of longer and higher rate hikes to contain inflation.