A balanced response to inflation

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Although some supply shortages were anticipated as the global economy reopened after the Covid-19 shutdowns, they turned out to be more widespread and less transitory than expected. In a market economy governed at least in part by the laws of supply and demand, shortages are expected to affect prices. And when the individual price increases are lumped together, we call it inflation, which is now at levels not seen for many years.


Nonetheless, my biggest concern is that central banks are overreacting, raising interest rates excessively and hampering the nascent recovery. As always, those at the bottom of the income scale would suffer the most in this scenario.

Several things stand out from the latest data. First, the inflation rate has been volatile. Last month, the media made much of the 7% annual inflation rate in the United States, failing to point out that December’s rate was barely more than half of October’s. With no evidence of an inflation spiral, market expectations – reflected in the difference in yields between inflation-linked and non-inflation-linked bonds – were duly moderated.

One of the main sources of higher inflation has been energy prices, which rose at a seasonally-adjusted annual rate of 30% in 2021. There’s a reason these prices are excluded from “ underlying inflation. As the world moves away from fossil fuels – as needed to mitigate climate change – some transition costs are likely, as investments in fossil fuels may decline faster than increases in alternative supplies. But what we see today is a naked exercise of market power by oil producers. Knowing that their days are numbered, the oil companies are reaping whatever profits they still can.

High gasoline prices can be a big political problem because every commuter constantly faces them. But it’s a safe bet that once gasoline prices return to more familiar pre-Covid levels, they will no longer fuel the remaining inflation momentum. Again, knowledgeable market watchers already recognize this.

Another big issue is used car prices, which have highlighted technical issues in the construction of the consumer price index. Higher prices mean sellers are better off vis-à-vis buyers. But the consumer price index in the United States (unlike other countries) only reflects the buy side. This indicates another reason why inflation expectations have remained relatively stable: people know that the rise in used car prices is a short-term aberration that reflects the shortage of semiconductors that is currently limiting supply. of new cars. We know how to make cars and chips as well today as we did two years ago, so there’s every reason to expect those prices to come down, leading to measured deflation.


Moreover, given that much of current inflation stems from global issues – like chip shortages and the behavior of oil cartels – it is a stretch to blame inflation on excessive fiscal support in the United States. Acting alone, the United States can only have a limited effect on world prices.

Yes, the United States has slightly higher inflation than Europe; but it also experienced stronger growth. US policies have prevented a massive increase in poverty that might have happened otherwise. Recognizing that the cost of doing too little would be enormous, American policymakers did the right thing. In addition, some wage and price increases reflect the good balance between supply and demand. Higher prices are believed to indicate scarcity, redirecting resources to “solve” shortages. They do not signal a change in the overall productive capacity of the economy.

The pandemic has revealed a lack of economic resilience. Just-in-time inventory systems work well as long as there is no systemic problem. But if A is needed to produce B, and B is needed to produce C, and so on, it’s easy to see how even a small disturbance can have outsized consequences.

Similarly, a market economy tends not to adapt as well to big changes like a near-complete shutdown followed by a restart. And this difficult transition came after decades of underemployment for workers, especially those at the bottom of the wage scale. It’s no wonder the United States is experiencing a “great quit,” with workers quitting their jobs to seek better opportunities. If the resulting reduction in labor supply translates into wage increases, it would begin to rectify decades of low to non-existent real (inflation-adjusted) wage growth.

In contrast, rushing to curb demand whenever wages begin to rise is a surefire way to ensure that workers’ wages fall over time. As the US Federal Reserve now considers a new policy direction, it should be noted that periods of rapid structural change often require a higher optimal inflation rate, due to nominal downward wage and price rigidities (this which means that what increases rarely comes back). We are in such a period now, and we should not panic if inflation exceeds the central bank’s 2% target – a rate for which there is no economic justification.

Any honest account of current inflation has to come with a big disclaimer: as we’ve never experienced anything like this before, we can’t be sure how things will turn out. We don’t know what to make of the Great Resignation either, although there’s no doubt that the workers below have reason to be angry. Many marginal workers may be forced to return to work once their cash reserves are exhausted; but if they’re unhappy, it might just show in the productivity numbers.

What we know: A generalized sharp increase in interest rates is a cure worse than the disease. We must not tackle a supply problem by reducing demand and increasing unemployment. It might curb inflation if pushed far enough, but it will also ruin people’s lives.

What we need instead are targeted structural and fiscal policies aimed at unlocking supply bottlenecks and helping people cope with today’s realities. For example, food stamps for the needy should be indexed to the price of food and energy (fuel) subsidies to the price of energy. Beyond that, a one-time “inflation-adjustment” tax cut for low- and middle-income households would help them through the post-pandemic transition. It could be funded by taxing the monopoly rents of the oil, tech, pharmaceutical giants and other companies that have been a hit during the crisis.


The author, Nobel laureate in economics, is a professor at Columbia University and a member of the Independent Commission for the Reform of International Corporate Taxation. © Syndicate Project, 2022





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