The writer, a faculty member at Yale University and former Morgan Stanley Asia chair, is the author of ‘Unbalanced’
Echoes of an earlier, darker period of economic history are growing louder. When I warned in early 2020 of a 1970s-style stagflation, my concerns were primarily on the supply side. Today a full-blown global supply shock is at hand: energy and food prices are soaring, shipping lanes are clogged and labour shortages prevalent.
One popular theory is that supply disruptions and price spikes are transitory glitches related to the pandemic that will ultimately self-heal. The inflationary build-up of the early 1970s was also presaged by a focus on transitory events: the Opec oil embargo and El Niño-related weather disturbances.
Then, as now, central bankers preached the transitory inflation gospel. In the 1970s, US federal reserve chair Arthur Burns asked his research staff to purge transitory factors from popular price indices. Burns, convinced that the Fed should only respond to underlying inflation, kept taking more out of the core until there wasn’t much left. Only then, did he concede there was an inflation problem.
I was part of the staff involved in that regrettable exercise to create the first measure of core inflation, on the team that developed new metrics and wrote brilliant reports that no one ever read.
The current generation of central bankers is much wiser. They use more sophisticated models than we did in the 1970s. They think less in terms of nominal interest rates and more about real, or inflation-adjusted, rates. They are also luckier. The inherent asymmetries of globalisation have injected greater supply than demand, with developing nations such as China having focused more on production than consumption.
But today’s central bankers are flying blind in one important respect: they have forsaken the tools of interest-rate targeting for a balance-sheet approach to monetary policy supported by a breathtaking quantitative easing. Therein lies a serious risk that was not present in the 1970s. Central bankers haven’t a clue about the links between their asset holdings and the forces of supply and demand that are currently wreaking havoc on inflation.
This has lured them into a “sequencing trap” — responding to surprises, such as inflation, first through a tapering of asset purchases and then by raising the benchmark policy interest rate in baby steps. Yet aggregate demand is likely to be far less sensitive to central bank balance sheet adjustments than to the real cost of money, and monetary policy actions have a long lag time. This is particularly worrisome for the Fed, which has embraced a new “average inflation targeting” approach designed to delay policy responses to compensate for earlier undershoots of inflation.
The other problem is that today’s impaired supply chains cannot be repaired quickly. Research has shown that global value chains take considerable time to put together — and even more to reconfigure. A recent White House task force report came up with a long list of recommendations to ensure US supply chain resilience, including reskilling workers, revitalising American manufacturing and increased research and development spending. It is hard to argue with any of those proposals. But they are all long-term fixes that do not address the immediate supply shock of 2021.
I am not surprised at what has happened over the past 18 months on the supply side. Global value chains had become an engine of global trade and growth, as well as an important source of disinflation. Yet, in the search for increased efficiencies, these chains were stretched taut and have become increasingly fragile. They were also susceptible to the political backlash of “reshoring” manufacturing as protectionist rumblings grew louder.
The bigger surprise has come from the demand side. Few guessed the global economy would snap back from the Covid-induced lockdowns with such extraordinary vigour. As economies now slow from their rapid recoveries, that will leave the level of aggregate demand uncomfortably high relative to an impaired supply side. To me, that spells an enduring inflation problem.
That is the biggest risk of the sequencing trap. As brilliant and lucky as they have been, today’s generation of central bankers is afflicted with the same sense of denial that proved problematic in the 1970s. Due to a lack of experience and institutional memory of that tough period, the risk of another monetary policy blunder cannot be taken lightly.
The lessons? Inflation is unlikely to peak soon. What seems transitory now will last longer than we think. And it will take far more monetary tightening than financial markets are expecting to avoid stagflation 2.0.