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A pedestrian walks near the Royal Exchange and the Bank of England in the City of London on December 28, 2020. The central bank’s chief economist has warned that UK inflation is likely to hit or surpass 5 per cent by early next year. Photo: AFP
Opinion
Macroscope
by David Brown
Macroscope
by David Brown

Central banks should resist hitting the panic button on inflation

  • A return to tougher monetary policy is not the answer as higher inflation this year will eventually subside in 2022
  • This is a different world from the high inflation 1980s when annual consumer price rises reached 14.6 per cent in the US and interest rates surged to 22 per cent
David Brown
David Brown
Why you can trust SCMP
Inflation expectations are suddenly becoming a problem, with the markets seemingly rattled about the prospect of higher prices becoming embedded, central banks ending up on a war footing and the end of easy money coming a lot sooner than expected.
It’s really down to which side of the fence you are on. You are either an inflation believer or you see the surge in headline consumer price rises as a temporary spike, which should settle down once the increase in energy prices and global supply-side shortages ease over the next year.

We are still getting over the pandemic, recession risks are not too far behind and there is a good chance that inflation fears are being overdone. Bond market vigilantes may have you believe we are returning to some kind of 1970s-style stagflation and interest rates are about to surge, but thankfully there are enough cool-headed central bankers resisting the temptation to hit the panic button.

A return to tougher monetary policy is not the answer as higher inflation this year will eventually subside in 2022.

This does not mean global policymakers should bury their heads in the sand. The World Bank noted in its recent Commodity Markets Outlook that the recent surge in energy prices poses significant risks to global inflation, weighing on growth prospects in energy-importing countries.
Higher inflation is a tax on consumer spending, a disincentive for new business investment and a drag on growth, so it’s not surprising central bankers are worried. With US headline consumer price inflation pushing up to 5.4 per cent last month and no signs of a peak in sight, the US Federal Reserve is already talking about tightening its monetary policy belt as soon as next month.

Meanwhile in the UK, the Bank of England reckons that headline inflation will be heading over 5 per cent in the coming months, hinting that higher interest rates will follow soon. Central banks generally seem to be on amber alert ready for action with tougher policy.

Petrol and diesel prices are displayed at the entrance to a service station in Paris on October 22. French Prime Minister Jean Castex has announced a special inflation allowance of 100 euros (US$116) for people with a net monthly income of less than 2,000 euros. Photo: Xinhua

But is tougher monetary policy the right response for what seems to be a supply-side glitch? Waving higher interest rates at cost-push inflation risks is about as ineffective as Don Quixote tilting at windmills.

Higher pipeline prices are due to the spike in world energy costs and shortages in the global supply chain. There is no guarantee these will persist as the global economy unwinds from Covid-19 and economic activity normalises. There are no signs of domestic overheating pressures in any of the major economies which might be interpreted as posing any sort of demand-pull inflation risk.

It is no wonder Fed chairman Jerome Powell remains circumspect and is prepared to give the benefit of the doubt to a transitory phase of price rises that will eventually peter out.

Stagflation fears risk turning into self-fulfilling prophecy

The monetarist interpretation that the world is awash with excess money created by central banks through cumulative quantitative easing since 2008, and needs more restrictive monetary policy, is the wrong one in the current circumstances.

The world has just emerged from a deep systemic shock from the Covid-19 crisis, there is still a recessionary tailwind, wage pressures remain muted and employment levels are creeping back up.

This is a different world from the high inflation 1980s when annual consumer price rises reached 14.6 per cent in the US and interest rates surged as high as 22 per cent.

In retrospect, there is general agreement that tough monetarist policies adopted by the major economies went too far in depressing output and employment to fight inflation. Lessons should be learned. Unfettered monetarism was a disaster.

There is nothing to be gained from bashing global demand to fend off a transitory spike in global commodity prices which are beyond the central banks’ reach. There is a case for interest rates to be gently coerced from zero, but only when global demand conditions can cope. For the US, non-inflationary, sustainable interest rates are probably closer to 3 per cent.

In the long run, central banks must be patient. We need higher interest rates for the right reasons, to re-educate the world about a more responsible cost of money. We must move on from near-zero interest rates but a false dawn in global inflation risks should not be the excuse for an overreaction.

David Brown is the chief executive of New View Economics

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