April Fool’s Inflation Medicine Threatens Progress

Yves here. Because the dint of wrong-headed official and press messaging is so loud, it seems we have to keep debunking it. The current inflation is not caused by anything central bankers can address. Having them use their sledgehammer of interest rate increase will simply kill growth while doing little to alleviate the underlying cost pressures. Administrations around the world are guilty of dereliction of duty.

However to tackle inflation, officials would have to admit their Covid policies are misguided, the Russia economic sanctions backfired disastrously, and they’ve been asleep at the switch in fixing supply chain issues they could remedy, say perhaps trucker pay and work condition. But oh no, can’t admit error! Better to test if citizens will actually vote you out of office than admit to being responsible and try to clean up messes.

By Anis Chowdhury, Adjunct Professor at Western Sydney University and University of New South Wales (Australia), who held senior United Nations positions in New York and Bangkok and Jomo Kwame Sundaram, a former economics professor, who was United Nations Assistant Secretary-General for Economic Development, and received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought. Originally published at Jomo Kwame Sundaram’s website

The world economy is on the brink of outright recession, according to the International Monetary Fund (IMF). The Ukraine war and sanctions have scuttled recovery from the COVID-19 pandemic.

Over 80 central banks have already raised interest rates so far this year. Except for the Bank of Japan governor, major central bankers have reacted to recent inflation by raising interest rates. Hence, stagflation is increasingly likely as rising interest rates slow the economy, but do not quell supply-side cost-push inflation.

IMF U-turn Unexplained

The IMF chief economist recently advised, “Inflation at current levels represents a clear risk for current and future macroeconomic stability and bringing it back to central bank targets should be the top priority for policymakers”.

While acknowledging the short-term costs of raising interest rates, he has never bothered to explain why inflation targets should be considered sacrosanct regardless of circumstances. Simply asserting inflation will be more costly if not checked now makes for poor evidence-based policy making.

After all, only a month earlier, on 7 June, the IMF advised, “Countries should allow international prices to pass through to domestic prices while protecting households that are most in need”.

The Fund recognized the major sources of current inflation are supply disruptions – first due to pandemic lockdowns disrupting supply chains, and then, delivery blockages of food, fuel and fertilizer due to war and sanctions.

US Fed Infallible?

Without explaining why, US Federal Reserve Bank Chair Jerome Powell insists on emulating his hero, Paul Volcker, Fed chair during 1979-87. Volcker famously almost doubled the federal funds target rate to nearly 20%.

Thus, Volcker caused the longest US recession since the 1930s’ Great Depression, raising unemployment to nearly 11%, while “the effects of unemployment, on health and earnings of sacked workers, persisted for years”.

Asked at a US Senate hearing if the Fed was prepared to do whatever it takes to control inflation – even if it harms growth – Powell replied, “the answer to your question is yes”.

But major central banks have ‘over-reacted’ time and again, with disastrous consequences. Milton Friedman famously argued the US Fed exacerbated the 1930s’ Great Depression. Instead of providing liquidity to businesses struggling with short-term cash-flow problems, it squeezed credit, crushing economic activity.

Similarly, later Fed chair Ben Bernanke and his co-authors showed overzealous monetary tightening was mainly responsible for the 1970s’ stagflation. With prices still rising despite higher interest rates, stagflation now looms large.

North Atlantic Trio

Most central bankers have long been obsessed with fighting inflation, insisting on bringing it down to 2%, despite harming economic progress. This formulaic response is prescribed, even when inflation is not mainly due to surging demand.

Powell recently observed, “supply is a big part of the story”, acknowledging the Ukraine war and China’s pandemic restrictions have pushed prices up.

While admitting higher interest rates may increase unemployment, Powell insists meeting the 2% target is “unconditional”. He asserted, “we have the tools and the resolve to get it down to 2%”, insisting “we’re going to do that”.

While recognizing “very big supply shocks” as the primary cause of inflation, Bank of England (BOE) Governor Andrew Bailey also vows to meet the 2% inflation target, allowing “no ifs or buts”.

While European Central Bank President Christine Lagarde does not expect to return “to that environment of low inflation”, admitting “inflation in the euro area today is being driven by a complex mix of factors”, she insists on raising “interest rates for as long as it takes to bring inflation back to our [2%] target”.

April Fools?

Much of the problem is due to the 2% inflation targeting dogma. As the then Governor of the Reserve Bank of New Zealand – the first central bank to adopt a 2% inflation target – later admitted, “The figure was plucked out of the air”.

Thus, a “chance remark” by the NZ Finance Minister – during “a television interview on April 1, 1988 that he was thinking of genuine price stability, ‘around 0, or 0 to 1 percent’” – has become monetary policy worldwide!

Powell also acknowledged, “Since the pandemic, we’ve been living in a world where the economy has been driven by very different forces”. He confessed, “I think we understand better how little we understand about inflation.”

Meanwhile, Powell acknowledges how changed globalization, demographics, productivity and technical progress no longer check price increases – as during the ‘Great Moderation’.

Bailey’s resolve to get inflation to 2% is even more shocking as he admits the BOE cannot stop inflation hitting 10%, as “there isn’t a lot we can do”.

Although it has no theoretical, analytical or empirical basis, many central bankers treat inflation targeting as universal best practice – in all circumstances! Thus, despite acknowledging supply-side disruptions and changed conditions, they still insist on the 2% inflation target!

Interest Rate, Blunt Tool

Central bankers’ inflation targeting dogma will cause much damage. Even when inflation is rising, raising interest rates may not be the right policy tool for several reasons.

First, the interest rate only addresses the symptoms, not the causes of inflation – which can be many. Second, raising interest rates too often and too much can kill productive and efficient businesses along with those less so.

Third, by slowing the economy, higher interest rates discourage investment in new technology, skill-upgrading, plant and equipment, adversely affecting the economy’s long-term potential.

Fourth, higher interest rates will raise debt burdens for governments, businesses and households. Borrowings accelerated after the 2008-09 global financial crisis, and even more during the pandemic.

Monetary tightening also constrains fiscal policy. A slower economy implies less tax revenue and more social provisioning spending. Higher interest rates also raise living costs as households’ debt-servicing costs rise, especially for mortgages. Living costs also rise as businesses pass on higher interest rates to consumers.

Policy Innovation

The recent inflationary surge is broadly acknowledged as due to supply shortages, mainly due to the new Cold War, pandemic, Ukraine war and sanctions.

Increasing interest rates may slow price increases by reducing demand, but does not address supply constraints, the main cause of inflation now. Anti-inflationary policy in the current circumstances should therefore change from suppressing domestic demand, with higher interest rates, to enhancing supplies.

Raising interest rates increases credit costs for all. Instead, financial constraints on desired industries to be promoted (e.g., renewable energy) should be eased. Meanwhile, credit for undesirable, inefficient, speculative and unproductive activities (e.g., real estate and share purchases) should be tightened.

This requires macroeconomic policies to support economic diversification, by promoting industrial investments and technological innovation. Each goal needs customized policy tools.

Instead of reacting to inflation by raising the interest rate – a blunt one-size-fits-all instrument indeed – policymakers should consider various causes of inflation and how they interact.

Each source of inflation needs appropriate policy tools, not one blunt instrument for all. But central bankers still consider raising interest rates the main, if not only policy against inflation – a universal hammer for every cause of inflation, all seen as nails.

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  1. fjallstrom

    The point of the blunt tool is to make sure the burden of inflation always falls on the working class by preventing wages from rising. Because markets.

    At one point during the euro-crisis a document troika document regarding Spain stated the silent part out loud (but obfuscated in econo-speak) where it essentially described how unemployment needer to be even higher to prevent wages form rising. NAWRU, so to speak.

    1. flora

      Wages and wage increases are lagging far behind the real inflation rate. Wages aren’t driving inflation. Driving down wages won’t “cure” inflation, it will only make effective inflation at the store worse for wage earners. Note to Powell: This isn’t 1979.

      1. bdy

        Exactly. The point of driving down wages is never to “cure” inflation. It’s to keep wages down.

        Never forget that the “unemployment vs inflation” construct represents, for the banks, long term gains on money lent. 101 — Rising prices makes that $300k someone owes on their house a lot less than it could have been.

        The double-talk: “2% is bs but we’re still shooting for 2.” The hide: We were able to indirectly suppress workers’ pay for years with off-shoring and ZIRP, papering over stagnation with bubbles and private borrowing that conveniently laid the groundwork for the new #RentershipSociety, owned and operated by PE. Great for the books but now things are different. Time to consolidate the gains.

        Trust that buy low opportunities will emerge for those who are liquid, as the rest of us fall through the widening cracks of stagflation.

    2. Anthony G Stegman

      “Inflation” seems to include only the price of bread. The price of a house or a share of a company stock are not included. If we were honest about inflation we would have recognized that we have been in a high inflation environment for many years. Housing prices have gone through the roof. Until recently, the share prices of public companies have gone through the roof. The cost of medicines have been rising for decades. The cost of education has gone through the roof. I can go on. If central banks think they can reign in inflation the measure of their success should include lower housing prices, lower school tuition, lower prescription prices, lower share prices, and so on. To-date the central banks efforts to reign in inflation have been a miserable failure. Perhaps we ought not expect central banks to meaningfully influence inflation one way or the other. Other forces are at work.

      1. LAS

        Sometimes I don’t know what to think. At other times it’s confused thoughts like these …

        Over the past 6 months, we have seen some needed corrections, including for instance lower share prices once considered to be over-valued. Also, house prices have moderated somewhat. We none of us are particularly happy about it. But on the other hand, the people who benefited most from cheap money were the financial services making loans. Everyone else just got loan offers and debts.

        When money was cheap, it did NOT lead to appreciably more starter homes or decreasing homelessness. It contributed to more unaffordable housing, and to higher college and medical debts.

        Maybe the recent rises in interest rates are less the problem than the absence of public policy to address the needs of the most vulnerable domestic and global populations, the 80%. Passing effective socially responsible public policy seems to be the real problem.

        My knowledge is limited but as I understand this new legislation meant to combat climate change that Senator Schumer passed is in the same old vein … it seems to be about giving away tax cuts for purchase of products/services that use less energy, which benefits the well-off with spending power, or the top 20% of the population, and some corporations. The less wealthy 80% may not be able to participate in this whatsoever b/c they haven’t got the needed spending money. No one is giving those without spending power a use-able waiver or deal. And in this way we continue to promote inequality.

  2. Rolf

    Great informative post, thank you Yves.

    “I think we understand better how little we understand about inflation.”

    Like Jörmungandr, one end of his sentence consumes the other.

  3. flora

    Are Powell and other central bankers thinking the FIRE sector will again boom once they start lowering rates after inflation breaks, just as the FIRE sector boomed once Volcker’s rates started to come down? Lowering interest rates creating interest rate arbitrage in the 1980s and 90s creating profits captured by the FIRE sector. Is this a play to drive out small and medium sized businesses, leaving only the Wall St giants and monopolies standing?
    Hard to think of any other reasons for a broad, blunt raising of rates into *this* inflation.

  4. omg

    “…Raising interest rates increases credit costs for all. Instead, financial constraints on desired industries to be promoted (e.g., renewable energy) should be eased. Meanwhile, credit for undesirable, inefficient, speculative and unproductive activities (e.g., real estate and share purchases) should be tightened…”

    Are you suggesting that Biden should appoint a credit tzar to decide how credit flows into the economy, what is speculative and what is not?
    I also always struggle with this question, interest being the price of money, how does the Fed know what it should be?

    1. flora

      Generally it’s the tax system that “encourages or discourages” certain economic activity: if you want more of something you lower the tax on that something (tax deductions for home ownership, for dependent children and dependent adults, for capital depreciation of business property/equipment, etc). If you want less of something you raise taxes on it: sin taxes on tobacco and alcohol, the sale of precious metals taxes are higher – at the art and collectibles rate – than the tax rate for sale of real estate or cars or stocks, etc.

      You get the idea. This worked pretty well until both partied decided they loved tax breaks for the richest corporations and people, no matter what distortions that caused in the real economy; decided that regulations are bad; decided that Main Street didn’t matter. So now the Fed is asked to do something the Congress should be doing but won’t. imo.

  5. TomDority

    Raising interest rates to curb demand. So I guess people just started to eat more, need more shelter, and need more health and need more well paying jobs …. well the financialized economy can’t have that…. my gosh…. how on earth can they contribute to GDP if not allowed to gouge and extract like the landlords and ladies, princes, queens and kings of yore. Industrial Capitalism, public spending to lower costs of living and working (fourth leg of production) is so outdated and so yesterday….. Its privatization, finacialization, predatory and kleptocratic, asset puffing, bubble blowing and access control that rules the day. Forever wars forever because YBGIBG.
    Besides, you got to make the mass of people so utterly disappointed with the now to have them ready to accept whatever BS, Slogan or puffery offered to support a better future.
    “”what Pascal said of an effective religion is true of any effective doctine: it must be “Contrary to nature, to common sense and to pleasure.”” The True Believer – Eric Hoffer
    I would recommend it reading

  6. spud

    as far as fixing the supply chains that are behind much of the inflation, people that think they can do it, they are as smart as paul volker, SARC!

    when i was a boy there were no federal freeways in my state yet. so the best one heading north in my state, was a state highway, only partially four lanes wide. then it went to two lanes further north.

    the national guard training grounds was in the north of the state, the best route was the lone partial four lane state highway heading north.

    so vast convoys of national guard trucks would head north on the state highway.

    anyone ever watch something like that knows that the lead truck is doing about 50-55 M.P.H., and the trucks following would have to go ever faster to keep up, many stragglers fell well behind, they simply could not drive fast enough to keep up.

    well because it was a state highway and not a federal free way. cross streets and county roads in many cases had stop lights. these were long and drawn out affairs because of heavy traffic crossing the highway, everyone wanted to use that highway because it was four lanes wide.

    so you had waits at those lights, sometimes many minutes long. 5-10 minutes was not unheard of.

    meanwhile the pile ups waiting for the light to change became immense. many stragglers caught up also, once the light changed, the massive flow would start again, the the whole massive flow never made it through many times, only to get stopped once again, rinse and repeat.

    that is how free trade operates. you could see it by ship locations as they cross the pacific and made it into ports. if you fixed the so called supply chains, more people would use them, and you will be right back where you started.

    this was all predicted by many back in the 1990’s, the immense burning of fossil fuels, the massive carbon emissions, the massive traffic jams.

    so the free traders had a answer, those massive ships that keep running aground. you cannot make this stuff up.

    if we had matter transfers and replicator machines, free trade might work then.

    but we don’t. re-industrialization is the only way out. no free trade democratic will ever do that.

    those types of democrats have long memories all the way back to Andrew Jackson. FDR and Truman interrupted that cult. but Bill Clinton restored it.

  7. .Tom

    I feel that part of the problem comes from the vague and confusing the word inflation. When I was a kid in the 70s, it seemed to mean a combination of price increases and wage increases that led to devaluation of currency, assets and debts. But today it seems only to refer to price increases.

    /me confused

    1. dermotmoconnor

      Volcker played all kinds of games with the definition of ‘inflation’ – exculding things that any sensible person would include, IIRC. Still going on.

  8. Kenisha

    Sit down strike.
    Sitting on my purse.
    My man’s sitting on his wallet until these fools are out of office.

    Instead of buying, borrow. Replace borrowed items next year.
    Every house is like a corner store, except for food and gas.

  9. Oh

    The Fed’s unemployment target is to keep unemployment above the target. The Fed’s main goal is to toy with interest rates to allow inflation of assets like homes and stocks to inflate and promote borrowing. It’s time to get rid of the Fed.

  10. Left in Wisconsin

    I only take issue with one statement here: Although it has no theoretical, analytical or empirical basis, many central bankers treat inflation targeting as universal best practice – in all circumstances!

    While it certainly has no empirical basis, as far as I can tell all mainstream (and thus banker-friendly) macro-economists seem to subscribe to the (theoretical/analytical) view that the main driver of inflation is “inflationary expectations,” which is just another version of Krugman’s confidence fairy. I think that is what accounts for the near unanimity of central bank action and verbiage. Even as they admit there may be little they can do, they are compelled to say they will do what is necessary.

    The fact that what is necessary always crushes the little guy/gal is I’m sure just a coincidence.

  11. Watt4Bob

    The fact that what is necessary always crushes the little guy/gal is I’m sure just a coincidence.

    When the only tool you have is a hammer…

  12. Susan the Other

    Ideally a “free market” would be a market-wide system of brokers. Supply and demand brokered for the best sale. One big auction 24/7. When it gets out of balance, when prices get too high and somebody is monopolizing supply, etc. then the Fed steps in and raises interest rates to keep the entire economy from contagion. We need a different kind of broker for price controls. Actually the broker for the value of the currency. One that sets a fair price for goods without damaging the entire economy. But the favorite method is still the Fed because the Fed directly supports the value of the dollar and thus the finance industry. Whereas a trade-goods broker simply goes for the best price between supplier and purchaser – and if that price happens to be getting more expensive, so be it – if it is not price fixing. I’m assuming that if all prices were allowed to fluctuate within an established range, instead of being throttled by interest rates, the economy itself would not suffer deep recessions and rocket inflation at all. So my question is, would price controls control a steadier economy and wouldn’t that be a better support for the dollar?

  13. Anthony G Stegman

    When I read the varied postings on Naked Capitalism the juxtaposition between the climate emergency and the economy results in all kinds of cognitive dissonance. On the one hand the climate emergency requires that we all reduce our consumption of energy, along with much of everything else we consume. Yet, economic growth remains the holy grail of our society. We can’t have both. So if the Fed policies result in recession, that can actually be seen as beneficial to tackling the climate emergency. Imagine what the world be like had there been no recessions over the past 40-50 years. I shudder the thought!! Arguments that economic recessions hurt the most vulnerable among us are valid, but to a point only. What is necessary is no growth, or even de-growth, with a significant redistribution of wealth. A rising tide may lift all boats, but it may also drown us. Rather than raising the tide we need to put all boats on an even keel. Or as close to an even keel as we can accomplish.

    1. Jeff N

      Yes but there needs to be a limitless safety net for the working class *before* we can start reducing growth.
      Tell an oil worker he needs to stop to save the environment, and he will punch you. Gotta have something equal/better ready for him before you even *suggest* it.

    2. fjallstrom

      Ideally, a planned de-growth would have started with getting rid of the most conspicious consumtion, for example private jets, and then working from there. But it looks very much like we are in for messy de-growth of the real economy, wheter we want it or not.

      De-growth and inflation comes down to the same question: who shall have less? The central banks default position is that workers shall have less. Some much less by being made unemployed, the rest still less through not daring to demand sufficient wage increases from fear of ending up in the first group.

      Another approach – one that has been used time and again in wars – is to print the money to employ all and then try to control prices. Today there is a lot of prices that could be brought down through breaking up monopolies. In practise this would mean inflation, but the average person would still have a job and the full employment would mean wage increases. Depending on how severe the lack of goods is, most may still end up with less stuff. Think the home front in the US during world war II. Lots of jobs, not a lot of consumer goods. Victory gardens, etc. I see that as de-growth through inflation, even as the nominal economy keeps growing.

      But the latter scenario means that large capital owners huge mountains of wealth could buy less, and in particular it would mean that their power is diminshed. And they are quite opposed to losing power.

      1. Susan the Other

        As long as the entire world goes for your “de-growth through inflation” then the rich guys won’t lose that much altitude and they might not be too unhappy. If this is world wide inflation-recession, as Stephanie Kelton thinks, it could all work quite well.

    3. hk

      I don’t think “growth” is so important because it is some kind of “holy grail.” Growth is far simpler for “politics.” Without growth, anything that anyone gains has to be forcibly taken from someone who will naturally resist and the society would be beset with violence, metaphorical or literal. A peaceful society requires something that can provide everyone with something without taking from anyone, and growth is the necessary condition for this. What makes “growth” unacceptable to many people today is that this growth is not evenly distributed–many people lose while some gain–so it’s the “wrong” kind of growth. But by this token, no growth would be difficult to sell (at minimum, everyone has to be able to keep what they have for them to buy into it, and that’s harder if there is no growth) and degrowth would be impossible to sell (nobody wants to lose what is “rightfully theirs” for someone else, so it quickly becomes some version of “degrowth for you (the weak) and not for us (the powerful).” I’m not going to say “degrowth” is a priori a fantasy, but, unless you have far more credibility than any human being ever could, it would be impossible.

      I think the idea of putting all boats on even keel is, at least in principle, built into the idea of rising all boats. Losses due to risk are (eventually at least) real losses, after all. If the alleged rising tide comes at risk to many, it’s another type of “wrong type of growth,” I should think.

  14. Rodger Malcolm Mitchell

    Today’s inflation, and indeed every inflation in history, has been caused by shortages of crucial goods and services. They all have been supply-side cost-push inflations.

    No inflation in history has been caused by “excessive government spending” or by interest rates that are “too low.”

    Thus, to cure an inflation, we must cure the shortages. Period.

    For instance:

    Shortage of food: Federal aid to farmers. Education. Equipment. Insurance. Tax breaks.
    Shortage of oil: Aid to drillers. Aid to electric car/truck makers. Support for R&D alternative energy
    Shortage of labor: Eliminate FICA. Reduce tax rates on salaries. Provide Medicare for All.
    Shortage of lumber: Aid growers. R&D for alternatives. Tax breaks for alternatives
    Housing shortage: Aid home & apartment builders. Cut interest rates. Tax breaks for renters.

    Notice that curing inflation without recession requires MORE federal spending, not less, and lower interest rates, not higher.

    That is the way pre-WWII Germany cured its infamous inflation. Mr. Powell, how do you think a nation mired in devastating inflation and depression managed to pay for the most powerful war machine the world had ever known?

    1. Kurtismayfield

      Their goal isn’t to increase supply.. they want to reduce demand AND put millions out of work at the same time. They want to reduce demand from the working class only.

  15. steelhead23

    I agree that hiking interest rates now is likely to slow growth and will have only modest effects on price inflation caused by supply-chain issues. However, low interest rates spurred high rates of borrowing, increasing risks to financial stability. And much of this easy money was not being used to increase productivity but to speculate. As an example, housing prices rose by over 20% in many markets in 2021, driven largely by speculation fueled by easy credit. And while I don’t have the time to prove it, this easy money program enriched the wealthy and left the rest behind. As wealth disparity is also power disparity and the disparity in economic power among the citizenry diminishes the effectiveness of democracy, I support Powell’s foolish attempt to quell inflation by raising interest rates.

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