Larry Summers isn't all wrong – inflation expectations could become unanchored...
Sure, inflation in 2020 may indeed be transitory, but we should plot out a clear exit strategy so that inflation expectations don't become unanchored. Interview w/ financial historian Harold James...
I have not gotten the chance to write a deep-dive on the ongoing inflation debate. (I will try to do so soon.) But to quickly summarize the debate – some are worried that the $1.9 trillion stimulus package, combined with other factors like supply chain disruptions and pent-up consumer demand, could lead to higher-than-expected inflation in 2020 and 2021, and this could lead to disruptive dynamics in the markets, for the real economy, etc.
To be clear: we will almost surely see higher than 2% inflation in 2021, but the question is whether it will be transitory. The Federal Reserve and most economists believe this higher inflation will be a one-time thing and we shouldn’t worry about it. Former Treasury Secretary Larry Summers, however, is particularly worried about persistently higher inflation later, and he thinks that we are seeing the “least responsible macroeconomic policy in 40 years.”
Most of the economists I’ve come followed and listened to in the last few weeks – Ben Bernanke, Paul Krugman, Former NY Fed President Bill Dudley, Goldman Sachs Chief Economist Jan Hatzius, Apollo Chief Economist Torsten Slok, etc. – have sided against Summers, at least to some degree.
They largely believe that the economy still has a lot of slack (10 million jobs short vs. pre-pandemic so still a long way to go to overheat the economy); the Phillips Curve is flat so we can push down unemployment to a much lower level before seeing any inflation; and most importantly, it takes a long time for inflation expectations to become unanchored. (For more details on what it means to be “anchored” vs. “unanchored,” see here, here, or read my writing below).
Who’s Right on Inflation?
Harold James, Markus Brunnermeier, and Jean-Pierre Landau – three prominent scholars in economics & finance – published a piece on Project Syndicate titled “Who’s Right on Inflation?” on March 1st. That was a while ago but the insights are still very much relevant. I highly recommend reading the full article (which was not at all too technical to understand), and here’s the part that captured my attention the most:
Generally speaking, a one-off shock can be accommodated without long-lasting effects, because everyone recognizes that it is an exceptional event. But when there are repeated cycles of shocks and policy responses, a pattern emerges. People’s views of the future start to change as the exceptional becomes normal. In the language of central banks, expectations become unanchored.
The same reasoning can be applied to the COVID-19 pandemic. There is no doubt that large monetary and fiscal buffers were urgently needed to mitigate the immediate shock of the virus and the attendant economic lockdown. Were the buffer to be withdrawn at some clearly defined moment, there would be no long-term consequences for price expectations.
But like the coronavirus itself, economic malaise could linger as societies continue to suffer from the disease. The impact will not be evenly distributed. The tourism and travel industries will undergo severely delayed recoveries, and thus will demand continuing fiscal support.
…
With the same divergences that accompanied earlier shocks reappearing, we need a simple test to navigate the new-old inflation dispute. The key question is whether we can be confident that the state of exception will end. If we can clearly identify that moment, we need not worry about inflation.
But if one exception begets more exceptions, there will be no clear way out. Instead, expectations will shift, and inflation will increasingly factor into our vision of the future. That will create political uncertainty and acute polarization between countries run by fearful hawks and those run by self-confident doves.
What they’re essentially saying is – we can keep stimulating the economy as long as you give people a sense of when things will end, and inflation expectations will remain anchored as long as you can do so. However, if people really see no end to the current stimulative regime and gets too comfortable, that’s when the inflation expectations become unanchored, and all hell breaks loose.
Harold James on the history of exit strategy, inflation, central bank politics…
I was really happy to interview Prof. Harold James just about a week ago, when I asked him to share insights on inflation outlook in 2020. He is one of the most prominent financial and economist historians of our age. The bulk of the interview was about his most recent book Making a Modern Central Bank: The Bank of England, 1979–2003 – topics such as the modern history of central banking and global macro-financial trends in the last few decades. It is fascinating how the Bank of England transformed itself, and I recommend you giving it a watch/listen if you’re interested in central banks and financial history.
Here are the particular parts of discussion on inflation outlook between us, starting around 58 minutes in:
Tiger: [00:58:45] Could you tell us a bit more about your recent article “Who’s Right on Inflation?” Do you think our inflation expectations are becoming unanchored?
Harold James: The story is again learning from the past. Many people in the Obama Administration believed that the fiscal response to the 2008 global financial crisis had not been large enough, and that that was one of the causes of a relatively weak recovery and the poor showing of the Democrats in the midterm election in 2010, which kicked off the shellacking of the Obama Administration. So there's an absolute determination that must not occur again, and that determination is really baked into politics today.
But when the markets reflect on that, they will begin to wonder about the degree to which we have a really clear exit strategy from an unusual amount of fiscal stimulus, at a time in which the output gap, though difficult to measure, is not as substantial is in 2008 since the origins of the recession are really quite different – it’s not because of a total collapse of demand, but rather shutting down the economy to deal with the circumstances of the pandemic.
Tiger: Former Treasury Secretary Larry Summers has been voicing a lot of his concerns on inflation. He compared the $1.9 trillion stimulus package with the 1960s when Lyndon B. Johnson pushed for huge amounts of stimulus as a solution to the lack of fundamental growth, and soon rampant inflation kicked off. Do you agree with his historical analogy?
Harold James: Historically, big moments of inflation have come with major conflicts of war: In the United States, the First World War, the Second World War, Vietnam… And in the UK, you can go back further and look at the Napoleonic Wars.
In a sense, dealing with the Covid crisis is like a war – you need a complete mobilization of resources; it's unusual and unexpected. But it also has a kind of odd elements – we're going to find it difficult, I think, to say at any one moment that the war is over, especially when there may be new variants of this virus emerging, and there could be a lot of rationale to keep up the wartime state of things.
This is the background in the aftermath of World War II – when the Fed has to manage the interest rates in order to accommodate really large American public debt. They wanted to get out of that, but the Truman administration said we were in a national emergency facing a threat from the Soviet Union and fighting a war in Korea, so we shouldn’t want to do that. Hence, you end up finding it very, very difficult in those circumstances to make that decision and say: if you really want stability, you need to have an increase in interest rates that will make it more difficult to finance the government’s debt.
Tiger: It seems that we're kind of in a self-fulfilling bubble because it's very hard to define any clear exit strategies. I don't know how you define exit strategies in your context, but other people say that at least it's very hard to exit out of our current set of quantitative easing arrangements with the Federal Reserve's balance sheet blowing up by the trillions of dollars. Do you see that as a sign of the lack of an exit policy? If President Biden or Chair Powell say we won’t do more stimulus packages after this set of legislations, would you see that as defining an exit strategy?
Harold James: It would be a very difficult choice. Paul Volcker’s shock – dramatically raising interest rates to curb inflation in the 1980s – immediately had an effect, not just in the United States, but in the rest of the world. In particular, the Volcker shock really pushed up the cost of government borrowing for indebted countries and emerging markets, particularly pushing Latin America into debt crises.
Now we're in an environment where there's a lot of dollar debt, not just for countries but also amongst corporations. So changing the interest rates environment is very threatening, and people are worried about the spillovers.
I think one of the reasons that Larry Summers takes such a strong position is that he's precisely concerned with a spillover effects. The more you get yourself into the situation where the spillovers are so destructive, the more trapped you are to the policy.
I don’t think Larry Summers is all wrong…
Prof. James didn’t directly comment on this, but my takeaway is (which may or may not be accurate): We’re in an environment today where there seems to be unlimited stimulus and monetary support. Not only did we just pass the $1.9 trillion package, we might soon have another few trillion dollar worth of infrastructure legislation and more, and the Fed seems to be adament in supporting the markets and real economy with whatever it takes.
In those moments, it seems irrational to me to not fear that inflation expectations could have the possibility of being unanchored. In other words, sure, any price level shock in 2020 may indeed be transitory, but it is neverthelss dangerous to be complacent. If we do not plot out an exit strategy in our mind or communicate that clearly to the public, persistent inflation could arrive much sooner than we expect.
The Fed probably does not plan to bail out markets no matter what risks the market participants take, and Biden probably isn’t planning on rolling out Keynesian fiscal stimulus every year. But the fact that policymakers actually have an exit strategy probably no longer matters when the markets and the public perceive the policymakers to have no exit strategy. This is the real danger.
With that being said, I don’t think Larry Summers is all wrong… (We will dive into his specific arguments at another time)
The saga of inflation is to be continued…
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