What caused the great inflation?

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Disappointing US CPI inflation last week finalised the financial rout of those expecting the first cut in interest rates in March. Financial markets now think there is only a 10 per cent chance next month, compared with 90 per cent in late December. See a chart that matters for more on this below. My question is how much do these future interest rate moves matter? I’ll collate your thinking for a future newsletter. Email me:

More important than US CPI inflation

While financial markets dissected the price figures stateside, my focus was longer term. In an early draft of history, the Centre for Economic Policy Research published an important ebook on the monetary policy responses to the post-pandemic inflation, with contributions from most leading central banks and many top academics.

While some central bankers still adopt the irritating view that hindsight is not a valuable tool for assessing their decisions, most are now thankfully in lesson learning mode. That is the point of the book. In a well-judged introduction, Bill English, Kristin Forbes and Angel Ubide note that central banks underestimated the risks of inflation and should not fall into that trap again, successfully responded to the crisis once it was upon them, and have a reasonable chance of completing the job of normalising price movements.

Here is a summary of their specific seven lessons to learn:

  • Inflation forecasts failed and need a lot of work

  • Central bankers need to be much more wary about “looking through” supply shocks when interest rates are stimulating demand

  • Interest rates should be the primary tool of inflation control

  • They should move faster in response to events

  • Central bankers cannot ignore fiscal policy and should employ simulations if they feel unable to forecast likely fiscal responses before they have happened

  • With big government finance losses from higher interest rates, monetary and fiscal policy is harder than ever to separate

  • High interest rates exposed financial vulnerabilities in the US, UK and Switzerland. Central banks need to work harder to ensure they can achieve inflation ambitions without blowing up the financial system

What caused the great inflation?

The chapter of the ebook that will gain most attention is an international effort to explain the causes of the post-pandemic inflation in 11 countries. Authored by Ben Bernanke, former Federal Reserve chair now at the Brookings Institution, and Olivier Blanchard, former IMF chief economist now at the Peterson Institute, it is really a collaboration between the leading central banks. They all have a stab at extending last year’s paper by the same authors on US inflation to their own countries.

The beauty of the simple Bernanke-Blanchard model is its flexibility. There is an underlying Phillips curve relationship between tight labour markets and inflation at work, but it allows high inflation to be determined also by supply shocks, energy shocks and even (indirectly) by greedflation. The results therefore give an extremely helpful decomposition of the causes of inflation in different countries, all measured on a consistent basis.

Of course, like any sausage factory, the more you examine the insides of the model, the less appealing some aspects become, but that should not detract from its value in telling the big international story in a consistent way, driven by data, not anecdote.

The chart below with the results comes from a lot of modelling and simulation. Don’t go to the original paper for this chart as it is mislabelled there and the results are harder to see.

What follows is my interpretation of the results. Remember the Y-axis is not the annual rate of inflation, but the quarterly rate annualised, hence the sharp falls in 2022 in the US and 2023 in the eurozone. The blue line is the actual rate of quarterly annualised inflation.

First, look at the initial conditions in light blue. This is an attempt to assess how much inflation was in the pipeline in late 2019 before the pandemic. It is driven by past inflation out-turns and the pre-pandemic level of vacancies relative to unemployment. For the US, this shows mildly rising inflation from 2 per cent to almost 3 per cent because the labour market was already a little tighter than normal. For the eurozone and Japan, it suggests stable, but below 2 per cent inflation because there was not much that was unusual in the labour market in 2019 and past inflation out-turns had been below target. The UK appears to have a bit of an inflation problem already in 2019 because past inflation had been higher on average and vacancies were high relative to unemployment. It is probably best not to over interpret the UK line as suggesting the Bank of England was dangerously complacent about inflation in 2019.

The “high vacancies” darker blue bars show the evolution of the vacancies to unemployment ratio since the pandemic, suggesting tighter labour markets outside Japan have been adding 0.5 to 1.5 percentage points to inflation. This, the authors suggest is the demand-driven part of inflation caused by tight labour markets that needs to be removed with economic weakness (although the results suggest tighter labour markets are helpful for the eurozone to achieve its inflation target). The more recent reductions in US vacancies and the UK’s recession suggest that this is already happening. It does not scream that there is a lot more to do.

The pink and green bars show the specific food and energy-related shocks and demonstrate their overwhelming importance of pushing inflation higher over the past three years. For the US, the energy shock came in 2021, when higher oil prices pushed up the cost of road fuels. For Europe, high petrol taxes damp that effect, but the big shock came in 2022 after Russia’s invasion of Ukraine pushed natural gas prices to rise 11-fold. Europe had a much larger shock to withstand than the US.

Food price inflation, in green, followed the energy shock in Europe and was its direct result, since the energy component of many foods and fertiliser is large. Think about greenhouse grown tomatoes, which require energy-intensive heating and fertiliser to ripen the fruit. In Japan, food prices have driven much of its inflation.

Finally, look at the “shortage” component. This was generally estimated from Google searches of the word in each country on the understanding that shortages allow companies to raise prices. It can therefore include the concept of “greedflation”, since companies can exploit a shortage situation for profit, although this is not separately identified. It is strongest in the eurozone where there has also been most concern about rising profit margins and where the European Central Bank is encouraging a limited catch up of wages with inflation.

One thing to note is that the UK has a large shortage component in the third quarter of 2021, which I bet is entirely driven by the fuel pump panic buying that September and had next to no impact on inflation (so don’t look too closely).

Overall, the results suggest most of the inflation could be explained by one-offs, but the credibility of central banks also helped bring inflation back down reasonably rapidly. According to Bernanke and Blanchard, the job is still not quite complete.

Had the labour market not been too tight, there would have been little reason for central banks to react to inflation. Unfortunately, in most countries, labour markets are probably too tight, and this implies that the fight against inflation is not fully over.

What I’ve been reading and watching

  • For an alternative and much simpler take on the supply and demand causes of inflation, Joseph Gagnon at the Peterson Institute comes to similar conclusions as Bernanke and Blanchard. The data does point this way

  • Claudia Sahm, however, is someone who does not like Bernanke and Blanchard’s conclusion that more monetary work is still needed to reduce inflation. The former Fed official slammed the central bank for putting too much weight on Phillips curve ideas. Now is not the time for the Fed to drag its feet on rate cuts, she argues

  • Regardless of higher market interest rates, governments are increasingly resorting to desperate devices to improve the fiscal outlook. Beware fiscal fairy tales I warned in my column last week

  • In a timely warning, Eswar Prasad, senior fellow at the Brookings Institution, highlights China’s tendency to delete data series that show worrying signs. The authorities want to create good vibes, but it doesn’t instil much confidence in them and, Prasad argues, is no substitute for action

A chart that matters

In February, financial markets have pared back expectations of rate cuts for the US, eurozone and UK. The charts show how much forward markets have shifted in just over two weeks. Financial markets now forecast slower monetary easing and fewer rate cuts in total with interest rates settling at a higher level. Economists must be laughing at how bad financial markets are at forecasting. In October they thought interest rates would stay higher for a lot longer, got bullish about rate cuts in December and have flip-flopped again. Perhaps forecasting is just difficult.

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