The US Federal Reserve can’t risk a return to the high inflation of the 1970s and 1980s

Niggling fears over economic growth remain but with supply chain constraints still severe and energy prices that could spiral upwards under the threat of war in Ukraine, the Fed is right to raise interest rates as soon as possible

David Brown

Published: 5:45am, 1 Feb 2022

Why you can trust SCMP

It is any central banker’s worst nightmare – wondering whether their monetary actions may have whipped up a storm of needless inflation risks. With global interest rates so low and the world economy on a robust recovery, it’s no wonder markets are so concerned that we may be heading back to the bad old days of high inflation seen in the 1970s and 1980s.

Supply-chain constraints, sharp energy price rises and niggling economic fears have all added to the dilemma of whether monetary policy is running too hot or too cold after the 2020 downturn.

There is no easy answer to where interest rates should be right now. We may not be heading into a hyperinflation catastrophe, but the old hype about the end of inflation now looks wildly premature. Inflation is coming back, interest rates are heading higher and the world just has to get used to it.

With US economic growth surging by 6.9 per cent year on year in the final quarter of last year, much higher than expected, it is no surprise that the US Federal Reserve’s patience has finally run out – especially with US consumer price inflation also surging by 7 per cent in December.

Near-zero US interest rates have outstayed their welcome and Fed chairman Jerome Powell has put the markets on short notice that higher rates could be on the cards as early as March.

In the Fed’s view, the odds are shifting towards inflation becoming more entrenched rather than transitory, especially with employment prospects bouncing back.

The US labour market seems in much better shape, with the headline unemployment rate at 3.9 per cent in December, closing in on its pre-pandemic cyclical low of 3.5 per cent in February 2020.

A more worrying development is that wage inflation pressures are heating up at the same time, with annual wages and salaries growth running at 8.8 per cent in November. Is the Phillips Curve, the inverse relationship between unemployment and wages, returning with a vengeance, especially as higher cost-of-living pressures begin to feed into demands for higher pay?

With skilled and unskilled workers in short supply, employers are under pressure to pay more to bring in new labour. It could mark the beginning of the end for the gig economy, zero-hours contracts and low wages. That may be one positive legacy of the pandemic, despite the huge cost of so many lives lost.

03:19

China’s delivery drivers pushed to the brink by food app algorithms

The Fed may be rightly obsessed with the deteriorating outlook for US inflation, but is there is a risk of hitting the panic button too soon? After all, there is an alternative view that suggests the world is not about to fall into a dangerous wage-price spiral raging out of control.

The International Monetary Fund offers a more positive outlook, suggesting that US inflation risks will peak in the first quarter of this year, eventually subsiding to the Fed’s consumer price inflation target of 2 per cent by 2023. There are still residual headwinds from the 2020 downturn dragging on growth, with spare operating capacity helping to contain price pressures.

Capacity utilisation levels in US industry are only running at 76.5 per cent in December, comfortably below peaks of above 80 per cent in earlier cycles.

The IMF also points to the risk that the United States and China, the world’s two largest economies, will be trending towards slower growth over the medium term, implying that recovery from the pandemic still needs nurturing.

The IMF’s belief that global inflation will peak this year probably presupposes that there will be some stabilisation in energy prices in the coming months.

02:27

Amid Russian troop build-up in Belarus, Ukrainian soldiers doubt good result in Kremlin-US talks

It is worth remembering that threat of war in Ukraine could throw any benign assumptions about the outlook for the global energy market into complete disarray.

Clearly, the impact of the post-pandemic supply-chain crisis and the energy price spike has thrown a curveball into earlier central bank notions about going easy on inflation to give global recovery a better chance.

That perceived passivity has been swiftly superseded. In the 1970s and 1980s, the transmission effect between higher energy prices and a vicious wage-price spiral was fast and furious, requiring an aggressive response from the global monetary authorities to contain the damage.

This time around, central banks can’t take any chances and the Fed is right to pull the trigger for higher rates as soon as possible. The age of monetary austerity has just begun.

David Brown is the chief executive of New View Economics