As part of our Global Fractures series, Charles Dumas, our Chief Economist, and Steven Blitz, our Chief US Economist, explain why monetary policy has failed to generate the desired levels of inflation.
Inflation targets have become perverse and unachievable. This leaves fiscal policy as the only potent tool in the next slowdown.
“Inflation targets as the primary goal of demand management policy were inspired by the huge 1970s damage from inflation averaging 10% or more in advanced countries. Alongside the 1980s curbing of inflation, monetarism achieved complete policy dominance, owing to the mix of its suitability for the task and analytical mistakes made by so-called ‘Keynesians’. The crude attitude of Keynesians originated in the 1920s and 1930s Great Depression, when purely monetary stimulus was likened to ‘pushing on a piece of string’. Though fair enough at the time, this became irrelevant in the era of high inflation: monetary restraint became a matter of ‘pulling’ on a piece string – and that, unlike its opposite, works. Other aspects of Keynesian economics, such as the ‘zero lower bound’ on nominal wages and interest rates, also ceased to be relevant in the context of high inflation.
As it happens, at least five other factors have come into operation over the past 30 years that have exercised major downward pressure on inflation, especially since the financial crisis (GFC) in 2007-09. Though not in order of priority, first, the savings glut build-up, which provoked the global imbalances of 2004-07, and thus helped cause the crisis, remained in place after it. The crisis forced deficit countries into austerity programmes, while the glut of saving in surplus countries was inherently a shortage of demand. Second, while budget deficits in 2009-10 arguably prevented the crisis lurching into depression, they were clawed back vigorously from 2011 onward in the US and Europe, reinforcing the deflation of demand. Third, the tech roll-out has been an essentially deflationary force since at least the mid-1990s. Fourth, globalisation (interactive with the tech roll-out) has both cheapened the price of many goods and services, and also caused the low-cost labour in EMs to put downward pressure on DM wages. Lastly, demographics have been anti-inflationary as the working age-groups in DMs and China have been a rising share of the total population until recently.
Inflation has fallen below its 2% target in Japan, the euro area (EA) and the US. Inflation targets therefore now require stimulus to increase inflation. Aside from higher inflation being an inherently perverse goal, it is in any case misconceived. The monetarist monopoly of demand management policy can only reasonably target nominal GDP, the right-hand side of the monetary equation, MV=PQ … and then only reliably if the velocity of circulation of money (‘V’ in the equation) is relatively stable and predictable.
The failure of central banks to achieve their inflation targets is most obvious in Japan and Europe. Japan’s problems stem from the excessive structural cash flow of business. Despite a massive 25-year loss of world market share, this has been ‘financed’ by willingness of the labour force to accept wage cuts. In the EA, the inability to reach target inflation stems from aggressive cuts in budget deficits in the teeth of the euro crisis in 2011-13, and the major imbalances of unit labour costs that have built up, especially between Germany and Italy. The resultant export dependence has been revealed as huge weakness by the side-effects of the Sino-US trade war. Meanwhile throughout the DMs, and particularly in the US, the search for ever-lower interest rates to raise inflation ignores the counter-flow from weak growth and low returns on capital.
It is seems clear that fiscal stimulus will come back into play soon, though the deeply embedded slowdown of growth and emergence of populism mean this will almost certainly be too little, too late. The need to encourage more, and more profitable, capex argues for vigorous Keynesian stimulus with the goal of getting long-dated government bond yields decisively above inflation. Ironically, this might lead to the 2% inflation targets being achieved, not least because, except for the tech effects, all the past 30 years’ depressants to inflation are being reversed.