Scary as it is, the argument that inflation is here to stay is winning

As the IIF warns of a global inflation storm, the fear is that raising interest rates in response could spark a recession – when governments and central banks are out of ammunition

Anthony Rowley

Published: 3:45am, 29 Nov 2021

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The inflation debate continues to rage and the Institute of International Finance (IIF), an association of many of the world’s biggest financial institutions, is talking of a “perfect global inflation storm”. Inflation has moved from the realm of fantasy into the realm of fear.

I wrote on this subject a week ago, but it is time to take “One Step Beyond” (to borrow the title of a 1950s US TV series) and imagine what might happen if an inflation-induced recession does occur. As with many episodes of the TV series, speculating on this could be a rather scary experience.

Let us suppose that inflation continues to accelerate rather than abate, and that rises in interest rates to halt its progress create a financial and “real” economic recession with a slump in stock markets, real estate and other markets, as well as in economic activity and employment.

This could prove to be one of those dream- or nightmare-like situations where the levers of power move slackly in the hands of policymakers, rather than with the feeling of firm contact with the economy, and when policy actions are about as effective as pushing on a piece of string, a saying attributed to John Maynard Keynes.

If further monetary stimulus were to be applied in such circumstances, it would be tantamount to “piling sin upon sin” (to quote a Biblical phrase from Isaiah) – and it simply would not work anyway. You cannot reinflate a burst bubble by blowing into it.

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Japan beef bowls and coffee costing more as workers feel the pinch from food price hike

As for further fiscal stimulus, governments have borrowed to the hilt to finance Covid-19 handouts and are in no position to play the white knights in a recession. We are about at the end of the road when it comes to “financing” our way out of trouble.

Meanwhile, as the IIF says, “inflation is on the rise fuelled by rising food and energy prices, deglobalisation, and supply chain disruptions”. These factors, plus high energy prices, may persist, leading to higher inflation next year, while “lingering and massive monetary easing adds to the problem”.

Output gaps, to quote the IIF, are narrowing and may turn positive next year in some advanced and emerging economies, with supply struggling to catch up with the rapid recovery in demand.

“Inflation may persistently exceed central bank targets due to expansionary policies and deglobalisation,” the IIF says. “Evidence suggests that the transitory [inflation] argument is becoming less persuasive as bottlenecks related to supply chain disruptions seem to be more persistent than previously thought.”

Meanwhile, energy prices are up and food prices have increased to their highest levels in nearly 10 years.

How can inflation be transitory if supply chain disruption is here to stay?

Inflationary pressures may broaden across the consumer basket, the IIF adds. “Long lags in the pass-through of higher energy costs to core CPI [consumer price index] may suggest that core inflation will remain high in 2022.” The inflationary impact of rising energy prices may be spread over several years.

Emerging Asian economies have seen relatively subdued rises in inflation and the pass-through from producer to consumer prices has been limited. Inflation expectations in Japan, China and Malaysia are below or around 2 per cent, suggesting better economic management there than in advanced economies.

In the match between Team Inflation (who believe that across-the-board surges in prices of merchandise and some services are here to stay) and Team Transitory (who believe inflation will work its way through the system by itself in time), the former seems to be scoring higher.

Playing for Team Transitory, economist Paul Krugman argued in The New York Times that US President Joe Biden’s American Rescue Plan of huge deficit spending hasn’t really boosted overall spending and inflation that much, and that withdrawals from the workforce are behind rising wages there.

01:30

Global supply chain crisis bites in US cities as store shelves empty with rising demand

Krugman argued that price rises caused largely by supply bottlenecks in the world’s latest economy should be tolerated, rather than responded to with interest rate increases, thereby risking the loss of “hundreds of thousands [or] maybe millions, of jobs”.

That sounds like a cry from the heart and casts Team Inflation in a bad light. But inflation can also wreak massive damage on employment as soaring prices destroy confidence in money, savings and investment. So the key question is whether we are mortgaging the future by “buying” growth.

Rather than pointing out how many times great episodes of inflation have proved temporary, Team Transitory should maybe think about how many times we have “bought off” economic recession in recent decades at the cost only of massive monetary creation by central banks.

As US debt piles up, what happens if faith in Treasuries is shaken?

True, this has avoided recession for a while but it has been at the expense of creating massive inflation in stocks and other financial assets as well as in property and other prices. Asset inflation has itself created a “wealth effect” that has spurred borrowing and debt creation.

If we accept that monetary stimulus and asset inflation cannot be relied upon to stimulate consumption and economic growth indefinitely (although a belief seems to have sprung up that they can), then there needs to be some systemic corrective. That may be inflation rearing its head now.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs