You may not realise it but you’re currently participating in a high-stakes trial of a new response to the pandemic, and no it’s not another vaccine. We’re all part of an economic policy revolution whose proponents say it will super-charge the recovery but whose critics fear it may take us back to the bad old days of runaway inflation.
You’ve probably heard a lot about inflation recently. Last week inflation in the UK rose from just 0.7 per cent to 1.5 per cent. The previous week saw an even bigger jump in the United States, up to 4.2 per cent. Cue warnings that the inflation genie is out of the bottle.
So what is this policy revolution? Central banks and governments have changed the way they think about inflation, with huge implications for all of us. Let me explain how.
Generally, a little bit of stable inflation is a good thing — it helps grease the wheels of the economy. But if it gets out of hand it can be very difficult to get back under control. The last time that happened in the Seventies and Eighties many economies had to endure recessions, high interest rates, soaring repossessions, plunging house prices and years of high unemployment. So if the inflation genie does get out of the bottle again, getting it back in would have serious side-effects for all of us.
That’s why, ever since the Eighties, central banks have seen their main role as bearing down on inflation from above to stop it getting out of control. But after the long and difficult recovery from the 2008 global financial crisis, they’ve turned that on its head. Their main aim now is to prevent economies getting trapped in a cycle of low inflation and low growth, where rock-bottom interest rates have less and less power to boost economies when recession hits.
This new revolution has gone furthest in the US though, and as usual in economics we’re all following in their wake. The US central bank — the Federal Reserve — is now saying they want to see inflation higher than their two per cent target. They actively want to run the economy hot in order to get as many people as possible into work, and they’ve said they won’t start to raise interest rates to cool things down until they’ve actually seen higher inflation for some time — “waiting to see the whites of its eyes” as the phrase goes. So is that happening already? No. What we’re seeing at the moment isn’t really inflation, it’s just prices adjusting to the lifting of restrictions. That might sound odd — after all, what is inflation if not prices adjusting? But actually they’re very different things.
Consider that recent jump in the US inflation data. Most of the monthly increase was due to hotels, air fares and used car prices. We all know that you pay more for a hotel or a flight during peak holiday season, yet we don’t suddenly worry about soaring inflation every July and December. The same thing is happening now as people start planning the holidays they’ve been denied. Similarly, used car prices jumped by 10 per cent in a single month, as people returned to their commutes and car manufacturers grapple with a temporary global shortage of the microchips that run modern cars. Nobody thinks that used car prices are going to go on rising by 10 per cent every month.
That’s what real inflation would look like — if our expectations for the future started to factor in repeated price increases in the goods and services we buy year after year. That’s when you’d see the vicious circle of inflation: employees asking for higher wages every year just to keep up with the cost of living, and companies passing on those wage costs in ever higher prices.
So the real test of this policy revolution isn’t a few temporary high inflation prints over the summer as economies reopen and prices adjust; it can only be judged over several years.
People’s expectations for future inflation are famously difficult to forecast, but thankfully it seems that they’re also pretty hard to shift, especially after many years of low and stable inflation. And a lot of people are still looking for work, so there’s plenty of scope for growth before inflation pressures start to build.
Most likely the policy revolution will keep our economies growing rapidly and creating more good jobs without letting our expectations for future inflation get out of control. If so, then, that trial we’re all part of will be judged a success and the Bank of England and Treasury will breathe a sigh of relief. If not then the side effects could be painful.
Rupert Harrison is a former chair of the Council of Economic Advisers and a multi-asset portfolio manager at BlackRock