The author is Vice President of BlackRock and was formerly Chairman of the Governing Board of the Swiss National Bank
Post-pandemic inflation has reached levels in the major developed world that we have not faced in two generations. Not surprisingly, this has led to widespread calls for central banks to aggressively tighten monetary policy. Financial markets have been quick to reassess their monetary policy outlook and markets now expect at least seven incremental rate hikes before the end of 2023.
The debate over how “temporary” inflation would end is missing the point. The root cause of this increase is more important.
Unlike at any point in the past 40 years, the main driver of the post-pandemic inflation spike is not excessive demand but limited supply capacity, recent research from the BlackRock Investment Institute shows.
Think of inflation as the sound of the economic engine. In the past it was caused by the engine revving too high. Today and in the foreseeable future, this is mainly due to supply side constraints that cause the engine to constantly fail.
These misfires occur on two levels: First, there are economy-wide constraints. As activities resumed after lockdowns, getting supply capacity up and running proved more difficult than getting demand going again. Even more important was a second type of misfire: the supply capacitance was in the wrong place.
The pandemic caused a sudden, sharp shift in consumer spending away from services and towards goods. Capacities – people and capital – cannot be expected to switch sectors so quickly. The result? Bottlenecks in manufacturing sectors as supply has struggled to keep up, but spare capacity in service industries. Constraints on the supply of goods result in higher prices, and while prices can fall in ailing sectors, they are typically tougher on the way down. This is driving up inflation even though the economy as a whole has not yet fully recovered.
The US economy is in exactly this momentum. The Covid-19 shock and the subsequent economic restart led to supply bottlenecks on a scale that was greater than in decades. Inflation has risen to levels not seen since 1982. But far from overheating overall, the economy has not even reached its estimated potential levels of output and employment.
So we are in a fundamentally different situation than Paul Volcker when he became Federal Reserve Chairman in 1979. At that time, the economy was running hot and it was necessary to push the deadlocked inflation out of the system.
But this isn’t a Volcker moment. The old playbook doesn’t apply: today we are in an era of severe supply constraints, even if economies are below potential. This changes everything from a macro perspective.
In principle, when inflation is driven by demand, prudent policies can stabilize both inflation and growth. This is not possible in a world where inflation is the result of supply constraints. Increased macro volatility becomes inevitable. Central banks must either accept higher inflation or be willing to literally destroy demand across the economy to ease supply constraints in part of it.
The long-term historical relationship between unemployment and inflation suggests that if central banks had tried to keep inflation close to their target of around 2 percent amid the supply constraints experienced in this restart, it would have meant doubling the unemployment rate. digit levels.
To minimize growth volatility, central banks will rightly want to live with supply-side inflation while long-term inflation expectations remain anchored. In fact, recent research suggests that they shouldn’t try at all to depress inflation caused by shifts in demand. Inflation helps make it easier to adjust to large changes in demand patterns.
It goes without saying that central banks should take their foot off the gas this year, reversing the highly accommodative monetary policy stance and yields to a more neutral stance. Resuming activity—unlike normal recovery—does not require a stimulus to be sustained. But what they should not do at this point is put on the political brakes to willfully destroy activities.
Precisely for this reason, the current monetary policy response to higher inflation is more muted than in the past. This is likely to remain so despite the current excitement over accelerated policy normalization. The best approach now is not to use monetary policy to destroy jobs and growth, but to reopen economies when public health concerns ease and the spending mix returns to normal. This will ease today’s acute inflationary pressures.
