The Great Inflation Trade-Off

On May 4, the United States Federal Reserve raised its benchmark interest rate by half a percentage point in an aggressive attempt to curb surging US annual inflation, which currently stands at a four-decade high of 8.3%. And eurozone inflation reached a record 7.5% year on year in April, according to preliminary estimates.

These sharp, sizeable price increases – accelerated by the war in Ukraine – are raising the specter of stagflation and may significantly erode households’ purchasing power. Vulnerable lower-income groups are likely to be most severely affected because they have limited access to financial markets, making it difficult for them to smooth their consumption. Furthermore, because prices increase more for the basic goods which dominate low-income households’ consumption basket, the rich-poor inflation gap – a phenomenon economists call “inflation inequality”– could widen further.

Just a few months ago, the price stability objective was exceptionally low in the growthinflation trade-off. Central banks, it was argued, should continue to focus on supporting the post-pandemic economic recovery. But now the critical question is whether monetary policymakers are doing enough to fight inflation. In the case of systemically important central banks, it is difficult to argue convincingly that they are considering the risks which have emerged.

For starters, major central banks’ forecasting failures enabled inflation to overshoot their 2% targets and potentially become entrenched. Inflation was trending upward and exceeded official targets on both sides of the Atlantic in the first half of 2021, but officials at the Fed and the European Central Bank stubbornly insisted that faster price growth was transitory.

That view contradicted their own monetary-policy rules and was inconsistent with the breakeven inflation rates – in the US, the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity – from implied market expectations. The five-year US breakeven inflation rate is currently about 3% (down from the record high of 3.59% in March 2022), and the Fed’s long-run neutral rate is around 2.4%.

Well-calibrated pre-emptive strikes are often desirable when managing inflation. The risk of wrongly accepting the low-inflation hypothesis and doing too little to prevent the threat from metastasizing greatly outweighs the risk of mistakenly rejecting the null hypothesis of low inflation. This is particularly true when the economy is overheating, because reversing inflationary trends becomes even tougher once inflationary expectations become de-anchored.

But this is precisely where the world now finds itself. Some leading central bankers – as part of their well-intentioned attempts to support the fragile post-pandemic recovery – decided not to pre-empt inflation, or even to respond to current price pressures until they were proven to be persistent.

A succession of shocks over the past few months have sustained the climb of consumer prices. These include supply-chain disruptions and bottlenecks, supply-demand imbalances, semiconductor shortages, and rising commodity prices. Upward wage pressures also have played a part, with a tighter labor market feeding through to higher prices, especially in the US.

While some of these shocks are potentially transitory consequences of the pandemicinduced downturn, most have been driven by structural changes, including the deglobalization process triggered by the US-China trade war. Likewise, supplychain disruptions – which are estimated to have added one percentage point to core inflation in 2021 – were exacerbated by the pandemic but in fact predated it.

Moreover, the earlier prolonged period of low inflation fueled the misguided belief that money creation is no longer inflationary. In 1993, then-Fed Chair Alan Greenspan argued that the historical relationships between money and income, and between money and the price level, “have largely broken down, depriving the aggregates of much of their usefulness as guides to policy.”

But the current inflation overshoot has perhaps validated Milton Friedman’s famous maxim: “Inflation is always and everywhere a monetary phenomenon.” The continued expansion of the money supply pushed the ECB and the Fed’s balance sheets to record levels in 2021, with M2 in the US increasing by $2.5 trillion last year. This was surely inflationary.

Jerome Powell, the current Fed chair, says that the US central bank has the necessary tools to rein in inflation. The Fed has begun deploying some of its arsenal, including tapering its asset purchases and raising interest rates, and may turn to other less commonly used tools to shrink the money supply further.

Unfortunately, the Fed must undertake these measures at a time of increasing stagflationary risks. Global growth is decelerating rapidly, and inflationary pressures are intensifying because of the commodity-price shock exacerbated by the Ukraine crisis.

The tools now being used by leading central banks will certainly help to contain inflation. But they will impose a high economic cost and could push the most vulnerable economies into recession.

Targeting the neutral rate of interest, at which monetary policy is neither contractionary nor expansionary, is difficult at the best of times. It is even trickier in a high-inflation environment when tradeoffs must be made. A wrong move now could easily spoil the incipient post-pandemic recovery.

Should that happen, the costs will likely fall disproportionately on emerging-market economies, and especially on low-income countries that are net importers of oil. Most of these countries were overleveraged when they emerged from the pandemicdriven downturn, and now face higher servicing costs on their US dollar-denominated debt. Their currencies are also depreciating sharply at a time when increasing currentaccount deficits and higher imported inflation have already forced some countries to make difficult monetary and fiscal policy trade-offs.

Striking the right balance between economic expansion and price stability is more art than science, but systemically important central banks must strive to achieve it in order to sustain global growth. Lately, the pursuit of that goal has been made markedly more difficult by the increasing frequency of policy-induced economic crises of choice, from the SinoAmerican trade war to the globalization of the Ukraine conflict.

“The job of the central bank is to worry,” said Alice Rivlin, a Fed vice chair in the late 1990s, and central bankers do have a lot on their minds these days, as globalization hastens the transmission of economic shocks generated by heightened geopolitical tensions. That is even more reason for them to avoid suboptimal policy choices that neither restore price stability nor foster economic growth.

Hippolyte Fofack is Chief Economist and Director of Research at the African ExportImport Bank (Afreximbank). Copyright: Project Syndicate, 2022. www.project-syndicate. org