By Marco Annunziata, Co-Founder, Annunziata + Desai Advisors, and Visiting Professor, Singapore Management University
Policymakers have made important but only partial progress in bringing inflation under control. Progress toward restoring macroeconomic policies to more normal settings remains similarly incomplete, and this will prove consequential and problematic in the long run—especially in an increasingly uncertain economic and geopolitical environment.
Headline inflation has dropped sharply from its near-double-digit peaks in the United States (US), the United Kingdom (UK) and the eurozone (EZ). Much of this decline owes to the fading of shocks in energy and supply chains, but decisive monetary-policy tightening has undoubtedly made an important contribution. Disinflation has so far been achieved with relatively little economic pain: The US economy continues to display remarkable resilience, to the point that consensus expectations of a recession have turned into a Waiting for Godot scenario; the labor market has cooled, but job creation maintains a healthy pace. The eurozone’s economy has lost momentum, especially in its main economic engine, Germany, but the worst fears of recession seem unlikely to materialize, and the labor market retains strength curiously out of line with the weaker pace of economic activity. The UK’s growth outlook appears shakier, but the economy should also manage to avoid an outright contraction.
The good news is that major Western central banks’ decisive and coordinated monetary-policy tightening has not tipped their economies into recession. The bad news is that disinflation progress remains incomplete. Both headline and core inflation still run well above the 2-percent target central banks have vowed to restore. Consumer prices in September were still rising at more than 6 percent per year in the UK, more than 4 percent in the euro area and close to 4 percent in the US. Whether and to what extent stubborn inflation should be a reason for concern remains a subject of intense debate, but here are some considerations worth pondering:
- Residual inflation pressures seem to have a life of their own, rather than just being the tail ends of past shocks: In the US, stronger price dynamics are being recorded in sectors that have not been affected by the pandemic whiplash. That is to say, the inflation we see today is not simply the result of pent-up demand built during the pandemic and then released.
- Wage growth continues to run at rates inconsistent with 2-percent inflation. The resurgence of strikes in Europe and the US flags the clear risk that wage pressures will persist. This does not necessarily imply that a traditional wage-price spiral is in the cards, but it certainly means that bringing inflation down to target will take more time and work.
- A new adverse supply shock is always around the corner. For example, Hamas’s horrific terrorist attack against Israel in early October has heightened the risk of a war in the Middle East that could send energy prices soaring again. This could create a scenario disturbingly similar to 1979, when the second oil shock reversed the ongoing disinflation. Analysts note that we have better energy efficiency and greater reliance on renewable energy today. But consider this: In 1979, fossil fuels accounted for 91 percent of global primary energy; today, they still account for 82 percent of a much greater total. A new energy shock would have severe impacts and could make disinflation efforts much more lengthy and costly.
To a prudent policymaker or corporate planner, this suggests we can’t assume total victory against inflation is only a matter of time. Major advanced economies may, in fact, be at risk of getting stuck in a “middle-inflation trap”. After graduating from low to middle-income status, many developing countries have struggled to rise further into the high-income ranks. Similarly, advanced economies may discover that dropping from high to middle inflation was the easy part, but reaching low inflation is much harder.
Some economists are openly asking whether driving inflation down to 2 percent is even worth it, given that it might require substantial sacrifices in the form of slower growth and higher unemployment. Some argue that central banks should formally raise their inflation target to 3-4 percent. Others suggest that central bankers should simply allow inflation to stabilize at a higher level, perhaps still claiming that the 2-percent target will be achieved in the fullness of time but with no intention of trying harder to bring it about. After all, would 3-4 percent inflation be that bad? In principle, it might not be. We should fear inflation volatility rather than high inflation rates. It is price volatility that disrupts economic planning for businesses and households. If we could trust inflation to run stable and predictable at, say, 20 percent per year, corporations and consumers could, in principle, plan as well as they can with 2-percent inflation. The problem is that we have found that the higher inflation gets, the more volatile it becomes. Would inflation stay stable enough at 3-4 percent? We do not know.
There might be no harm in trying to find out. What is more worrying is that calls for a higher inflation target seem to reflect a strong element of denial: a refusal to acknowledge that economic policies need to be reset to a neutral level, trusting the economy to grow on its own steam.
Monetary policy is arguably not even that tight yet. From the mid-1950s to the eve of the Global Financial Crisis (GFC) in 2007, the US real federal funds rate, measured as the nominal policy rate deflated by the contemporaneous CPI (Consumer Price Index), averaged close to 2 percent. The current real federal funds rate is about 1.6 percent. That is not that high, and it was still in negative territory as late as last April.
The Federal Reserve (the Fed), however, still projects that in the long term, the nominal federal funds rate should go back to 2.5 percent (from the current 5.25-5.50 percent). Assuming that inflation returns to its 2-percent target in the long run, that would imply a real policy rate of just 0.5 percent. That means the Fed is taking as “normal” the post-GFC stretch characterized by abnormally loose monetary policy with zero interest rates and massive quantitative easing. It would seem much more prudent to look back at the long-term pre-GFC average instead.
Monetary policy has reluctantly moved closer to a normal setting, but policymakers and most market participants seem to assume that this is only a passing unpleasantness and that we’ll soon return to a world of much lower rates.
At least for now, monetary policy has assumed a more prudent stance. The same cannot be said for fiscal policy, which stubbornly refuses to acknowledge reality. The US is perhaps the most egregious example. Recent estimates by the Congressional Budget Office (CBO) indicate that the US government’s 2023 fiscal deficit might be as high as 7 percent of gross domestic product (GDP). This would represent a substantial loosening from last year’s 5.5 percent in a year when economic growth has proved resilient and the labor market is close to as tight as it has ever been. There is hardly any need for this kind of fiscal stimulus.
US fiscal policy has become structurally looser. Between 1973 and 2008, the US fiscal deficit averaged a reasonable 2.5 percent of GDP. Post-GFC and through last year, it more than doubled to an average of 6.5 percent of GDP; for the next 10 years, it’s expected to average close to 6 percent. The US is not alone. According to the International Monetary Fund’s (IMF’s) latest estimates, budget deficits over 2023-28 will average around 4 percent of GDP in the UK and France and around 3.5 percent in Italy and Japan. Keep in mind that between 2007 and today, public-debt ratios have surged in most advanced economies (the ratio doubled in the US to 120 percent of GDP and surged to 150 percent of GDP in Italy). Financial markets are beginning to price in the high risks of these precarious fiscal outlooks through higher long-term bond yields. Governments, however, have not yet abandoned the delusion that they can spend their way to prosperity.
Elevated public-debt ratios and overly loose fiscal policies risk undermining future growth prospects. Persistent monetary expansions eventually resulted in high inflation, requiring a sharp rise in interest rates. Persistently loose fiscal policy will eventually require drastic expenditure contractions or further tax rises, making the private sector’s job even harder. Moreover, vulnerable fiscal positions leave governments with limited ability to react to the many potential economic shocks that could result from the increasingly uncertain geopolitical environment we face. Policymakers should waste no time returning fiscal policy to a more normal and sustainable setting.
This reluctance to face up to reality seems to extend beyond monetary and fiscal policies: ambitious public commitments to the energy transition are increasingly out of step with countries’ limited willingness to make the necessary sacrifices; immigration-welcoming rhetoric clashes with Western countries’ realization of the social and economic costs it entails; and universities’ growing focus on social goals is increasingly at odds with the need to bolster the human capital required for stronger future growth.
Rather than hoping for a quick return to looser monetary conditions, we should accept that a much broader recalibration of policies to a more normal setting is needed.