As excerpted from "Inflation: The defining macro story of this decade" a must-read report written by Deutsche Bank's global head of research, David Folkerts-Landau, co-authored by Peter Hooper and Jim Reid.
Ronald Reagan (1978): “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
Joe Biden (2021): “A job is about a lot more than a paycheck. It’s about dignity. It’s about respect. It’s about being able to look your kid in the eye and say everything will be okay. Too many people today can’t do that – and it’s got to change.”
Janet Yellen (2021): “Neither the president-elect, nor I, propose this relief package without an appreciation for the country’s debt burden. But right now, with interest rates at historic lows, the smartest thing we can do is act big”.
Jerome Powell (2021): “During this time of reopening, we are likely to see some upward pressure on prices … But those pressures are likely to be temporary as they are associated with the reopening process.”
Larry Summers, (2021): “I think this is the least responsible macroeconomic policies we’ve had in the last 40 years.”
The above quotes highlight that US macro policy and, indeed, the very role of government in the economy, is undergoing its biggest shift in direction in 40 years. In turn we are concerned that it will bring about uncomfortable levels of inflation.
It is no exaggeration to say that we are departing from neoliberalism and that the days of the new-liberal policies that begun in the Reagan era are clearly fading in the rear view mirror. The effects of this shift are being compounded by political turmoil in the US and deeply worrying geopolitical risks.
As we step into the new world, we are no longer sure how much of what we thought we understood about financial and macro-economics is still valid. We have lived through a decade of extraordinary and unconventional monetary stimulus to prevent economies from sliding into deflation, but this effort barely succeeded in propping up growth at what have been historically low levels.
The most immediate manifestation of the shift in macro policy is that the fear of inflation, and of rising levels of government debt, that shaped a generation of policymakers is receding. Replacing it is the perspective that economic policy should now concentrate on broader social goals. Such goals are as necessary as they are admirable. They include greater social support for minority groups, greater equality in income, wealth, education, medical care, and more broad-based economic opportunity and inclusion. They should be front and center of the policies of any government in these times.
The increased focus on these priorities can be seen not just in the ongoing expansionary policy response to the pandemic, but also in policymakers’ other longer-term objectives, such as combating climate change and tightening the social safety net. It is also evident in recent legislative and regulatory efforts to achieve a more balanced distribution of economic and political power between the corporate sector, labour, and the consumer.
Despite the shift in priorities, central bankers must still prioritize inflation. Indeed, history has shown that the social costs of significantly higher inflation and greatly expanded debt servicing obligations make it hard, if not impossible, to reach the social goals that the new US administration (among others) is keen to achieve. We fear that the vulnerable and disadvantaged will be hit first and hardest by mistakes in policy.
The foundation for today’s paradigm shift in policy was laid last decade. After the Global Financial Crisis, concerns turned to high and rising levels of sovereign debt. Market fears of peripheral Eurozone countries led governments to pre-emptively move towards fiscal consolidation before bond market vigilantes could force them. The effect of austerity was worsened as banks and consumers simultaneously tried to repair their balance sheets. Hence low interest rates and asset purchases continued even as economies were relatively stagnant and inflation stayed low.
Even before the pandemic, this orthodoxy was being increasingly questioned. Voters had rendered their verdict at the ballot box as inequality and lacklustre growth fuelled support for populist parties and unconventional leaders. Meanwhile, continued low inflation despite low interest rates led economists to be more relaxed about the levels of debt that countries could sustain.
The pandemic has accelerated this shift in thinking. Sovereign debt has risen to levels unimaginable a decade ago with large industrial countries exceeding red-line levels of 100% of GDP. Yet, there is little serious concern about debt sustainability on the horizon from investors, governments or international institutions. Similarly on inflation, the vast majority of central bankers and economists believe any rise in prices away from the historically-low levels of the last decade will be transitory. It is assumed that base line effects, one-offs, and structural forces will continue to suppress prices.
So two of the biggest historic constraints on macroeconomic policy – inflation and debt sustainability – are increasingly perceived as not binding. In turn, the removal of these constraints has opened the door for new goals for macro policy, which go far beyond simply stabilizing output across the business cycle.
This changing approach to macro policy has been formalized in the Federal Reserve’s operating procedures, making a broader interpretation of its mandate possible. Unlike in previous eras, when it was common practice to pre-empt inflation overshoots with higher rates, today’s Fed has said they want to see actual progress, not just forecast progress. The new average inflation targeting approach only increases tolerance for inflation.
Where the US leads, others tend to follow. Even in Germany, with its reliable fiscal discipline, there is growing support for to reform the constitutional debt brake in order to permit more deficit spending. And although in aggregate the EU’s fiscal stimulus has been more limited than that seen in the US, the arrival of the €750bn Recovery Fund financed by collective borrowing potentially opens the way for further such packages in response to future crises. It is hard to see the ECB stepping back from helping to finance such fiscal investments in the continent or moves to promote further integration.
In short, we are witnessing the most important shift in global macro policy since the Reagan/Volcker axis 40 years ago. Fiscal injections are now “off the charts” at the same time as the Fed’s modus operandi has shifted to tolerate higher inflation. Never before have we seen such coordinated expansionary fiscal and monetary policy. This will continue as output moves above potential. This is why this time is different for inflation.
Even if some of the transitory inflation ebbs away, we believe price growth will regain significant momentum as the economy overheats in 2022. Yet we worry that in its new inflation averaging framework, the Fed will be too slow to damp the rising inflation pressures effectively. The consequence of delay will be greater disruption of economic and financial activity than would be otherwise be the case when the Fed does finally act. In turn, this could create a significant recession and set off a chain of financial distress around the world, particularly in emerging markets.
History is not on the side of the Fed. In recent memory, the central bank has not succeeded in achieving a soft landing when implementing a monetary tightening when inflation has been above 4%.
Policymakers are about to enter a far more difficult world than they have seen for several decades.
We worry that inflation will make a comeback. Few still remember how our societies and economies were threatened by high inflation 50 years ago. The most basic laws of economics, the ones that have stood the test of time over a millennium, have not been suspended. An explosive growth in debt financed largely by central banks is likely to lead to higher inflation. We worry that the painful lessons of an inflationary past are being ignored by central bankers, either because they really believe that this time is different, or they have bought into a new paradigm that low interest rates are here to stay, or they are protecting their institutions by not trying to hold back a political steam roller. Whatever the reason, we expect inflationary pressures to re-emerge as the Fed continues with its policy of patience and its stated belief that current pressures are largely transitory. It may take a year longer until 2023 but inflation will re-emerge. And while it is admirable that this patience is due to the fact that the Fed’s priorities are shifting towards social goals, neglecting inflation leaves global economies sitting on a time bomb.
It is a scary thought that just as inflation is being deprioritized, fiscal and monetary policy is being coordinated in ways the world has never seen. Recent stimulus has been extraordinary and economic forecasting, which is difficult at the best of times, is becoming harder by the day. Fractured politics amplifies the problem. Needless to say, the range of global outcomes over the coming years is wide.
When central banks are eventually forced to act on inflation, they will find it themselves in a difficult, if not untenable, position. They will be fighting the increasingly-ingrained perception that high levels of debt and higher inflation are a small price to pay for achieving progressive political, economic and social goals. That will make it politically difficult for societies to accept higher unemployment in the interest of fighting inflation.
Eventually, though, any social priorities that policymakers have will be set aside if inflation returns in earnest. Rising prices will touch everyone. The effects could be devastating, particularly for the most vulnerable in society. Sadly, when central banks do act at this stage, they will be forced into abrupt policy change which will only make it harder for policymakers to achieve the social goals that our societies
Low, stable inflation and historically low interest rates have been the glue that have held together macro policy for the last three decades. If, as we expect, this starts to unravel over the next year or two, then policymakers will face the most challenging years since the Volcker/Reagan period in the 1980s.