HOW NOT TO FIGHT INFLATION
A careful look at US economic conditions supports the view that inflation was driven mainly by supply-side disruptions and shifts in the pattern of demand. Given this, further interest-rate hikes will have little to no effect – and will cause far-reaching problems of their own.
Despite favorable indices, it is too soon to tell whether inflation has been tamed. Nonetheless, two clear lessons have emerged from the recent price surge. First, economists’ standard models – especially the dominant one that assumes the economy always to be in equilibrium – were effectively useless. And, second, those who confidently asserted that it would take five years of pain to wring inflation out of the system have already been refuted. Inflation has fallen dramatically, with the December 2022 seasonally adjusted consumer price index coming in just 1% above that for June. There is overwhelming evidence that the main source of inflation was pandemicrelated supply shocks and shifts in the pattern of demand, not excess aggregate demand, and certainly not any additional demand created by pandemic spending. Anyone with any faith in the market economy knew that the supply issues would be resolved eventually; but no one could possibly know when.
After all, we have never endured a pandemic-driven economic shutdown followed by a rapid reopening. That is why models based on past experience proved irrelevant. Still, we could anticipate that clearing supply bottlenecks would be disinflationary, even if this would not necessarily counteract the earlier inflationary process immediately or in full, owing to markets’ tendency to adjust upward more rapidly than they adjust downward.
Policymakers continue to balance the risk of doing too little versus doing too much. The risks of increasing interest rates are clear: a fragile global economy could be pushed into recession, precipitating more debt crises as many heavily indebted emerging and developing economies face the triple whammy of a strong dollar, lower export revenues, and higher interest rates. This would be a travesty. After already letting people die unnecessarily by refusing to share the intellectual property for COVID-19 vaccines, the United States has knowingly adopted a policy that will likely sink the world’s most vulnerable economies. This is hardly a winning strategy for a country that has launched a new cold war with China.
Worse, it is not even clear that there is any upside to this approach. In fact, raising interest rates could do more harm than good, by making it more expensive for firms to invest in solutions to the current supply constraints. The US Federal Reserve’s monetary-policy tightening has already curtailed housing construction, even though more supply is precisely what is needed to bring down one of the biggest sources of inflation: housing costs.
Moreover, many price-setters in the housing market may now pass the higher costs of doing business on to renters. And in retail and other markets more broadly, higher interest rates can actually induce price increases as the higher interest rates induce businesses to write down the future value of lost customers relative to the benefits today of higher prices.
To be sure, a deep recession would tame inflation. But why would we invite that? Fed Chair Jerome Powell and his colleagues seem to relish cheering against the economy. Meanwhile, their friends in commercial banking are making out like bandits now that the Fed is paying 4.4% interest on more than $3 trillion of bank reserve balances – yielding a tidy return of more than $130 billion per year. To justify all this, the Fed points to the usual bogeymen: runaway inflation, a wage-price spiral, and unanchored inflation expectations. But where are these bogeymen? Not only is inflation falling, but wages are increasing more slowly than prices (meaning no spiral), and expectations remain in check. The five-year, five-year forward expectation rate is hovering just above 2% – hardly unanchored.
Some also fear that we will not return quickly enough to the 2% target inflation rate. But remember, that number was pulled out of thin air. It has no economic significance, nor is there any evidence to suggest that it would be costly to the economy if inflation were to vary between, say, 2% and 4%. On the contrary, given the need for structural changes in
The ongoing volatility in oil and gas markets has come as a shock to many people across the developed world. But its impact on developing countries that rely on producing fossil fuels has been far worse.
Over time, as the world increasingly shifts to cheaper and cleaner energy sources, fossil fuels will likely become less profitable, forcing energy-exporting countries to find other sources of income. What would that mean for “middleincome” developing countries which together account for 48% and 52% of global oil and gas output, respectively? While oil and gas have propped up the economies of countries like Nigeria, Mexico, Ghana, and Argentina over the years, dependence on them has led to a host of problems, from environmental pollution that harms public health to overreliance on fossil-fuel exports at the expense of the development of other sectors.
But breaking free from the addiction to fossil fuels will not be easy. Middleincome energy exporters are poorer than their developed-country counterparts and therefore have fewer resources with which to support workers and communities through the clean-energy transition. Nearly half the world’s fossilfuel workers live in Africa, Asia, or South America, and they would need to find new jobs – and the training to fill them. In addition, these countries’ oil and gas industries employ many more people indirectly, including contract workers who do not have the same protections as permanent and unionized workers. But worker displacement is only one of the risks for which middle-income countries must plan if they are to kick their fossil-fuel habit. Given that the oil and gas industries are a major primary source of their tax revenue, many cashthe economy and downward rigidities in prices, a slightly higher inflation target has much to recommend it.
Some also will say that inflation has remained tame precisely because central banks have signaled such resolve in fighting it. My dog Woofie might have drawn the same conclusion whenever he barked at planes flying over our house. He might have believed that he had scared them off, and that not barking would have increased the risk of the plane falling on him. One would hope that modern economic analysis would dig deeper than Woofie ever did. A careful look at what is going on, and at where prices have come down, supports the structuralist view that inflation was driven mainly by supplyside disruptions and shifts in the pattern of demand. As these issues are resolved, inflation is likely to continue to come down.
Yes, it is too soon to tell precisely when strapped governments would be unable to fund essential services, such as health care and education, if those proceeds suddenly disappeared.
Price volatility has already devastated economies that grew too dependent on fossil fuels. Following the 2020 crash in oil prices, for example, Nigeria proposed cutting education spending by up to 55%. And in response to the 2014 oil-price crash, Mexico pared public spending by close to 0.7% of GDP. Although high prices may lead to economic booms, they inevitably fall – and often drag down the economy with them. Ultimately, relying on finite resources is no way to fund a twenty-first-century economy. Developing and implementing the right strategies to shift away from fossil fuels will not happen overnight. But policymakers in middle-income energyexporting countries can already take three immediate steps to ensure that the cleanenergy transition does not harm their workers, communities, and economies – and that it lays the groundwork for a more prosperous future.
First, governments must engage in longterm planning, particularly when it comes to the economies of regions that would most likely be affected by the green transition. To that end, policymakers should consult various stakeholders, develop inclusive plans to help displaced workers and affected communities, and strengthen social safety nets. Closing data gaps regarding demographics, wages, and skills will be essential to assisting oil and gas workers, especially female workers.
Second, given that oil and gas revenues will most likely decline over the long term, middle-income exporters must double down on economic diversification. This would involve studying and developing other promising sectors, such as agricultural processing, manufactured goods, and business services. inflation will be fully tamed. And no one knows what new shocks await us. But I am still putting my money on “Team Temporary.” Those arguing that inflation will be largely cured on its own (and that the process could be hastened by policies to alleviate supply constraints) still have a much stronger case than those advocating measures with obviously high and persistent costs but only dubious benefits.
Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, is a former chief economist of the World Bank (19972000), chair of the US President’s Council of Economic Advisers, and co-chair of the High-level Commission on Carbon Prices. He is a member of the Independent Commission for the Reform of International Corporate Taxation and was lead author of the 1995 IPCC Climate Assessment.
By developing domestic clean-energy sectors, policymakers could complement their diversification strategies. Given the changing geopolitical landscape and growing demand for energy, renewables could stabilize prices, revenues, and employment. To support these efforts, governments should harness the power of civil society and the private sector, including oil companies.
Lastly, governments must provide the funding necessary to complete the cleanenergy transition. In the near term, they could use income from fossil-fuel production to diversify their economies and invest in green projects. They could also reallocate funds currently used for subsidy programs and require the oil and gas industries, especially multinationals, to help cover the costs of environmental remediation and support programs for affected workers and communities. But while middle-income countries could fund some of these measures by mobilizing internal resources, developed countries and international financial institutions must also offer the financing and technical assistance that these countries need to pursue their diversification strategies. Shifting away from fossil fuels is not only necessary to avert a climate catastrophe, but also represents an opportunity to build a healthier and more equitable future for all. But developed countries must not expect middle-income fossilfuel exporters to give up their main revenue source without international assistance. Ensuring that the net-zero transition does not leave anyone behind is a moral imperative. It is also smart climate policy.
Carlos Lopes, a professor at the Nelson Mandela School of Public Governance at the University of Cape Town, is a member of World Resources Institute’s Board.