Global inflation crisis looms because central banks let economies ‘run hot’

Contrary to the hopes of policymakers and pundits, the global surge in inflation could be about to get worse instead of returning to normal
Countries that are ‘running their economies hot’ to maintain output and employment are instead fuelling a potential global economic disaster

Anthony Rowley

Published: 12:30am, 29 Aug, 2022

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Almost everyone knows by now that inflation has reached scary levels, and fewer people are prepared to dismiss the phenomenon as “transitory”. But what if the nightmare is only beginning and inflation could go far higher before draconian policy actions rein it in?

Research presented to the Jackson Hole annual meeting of central bankers in Wyoming at the weekend suggests this could be the case. It has grim implications for financial markets, debt burdens, future unemployment rates and, of course, soaring price levels.

Some still take comfort in the notion that as the Covid-19 pandemic subsides and global supply chains return to “normal”, inflation will fall below double-digit levels and subside along with interest rates. The war in Ukraine will end and all will be well.

Things were never going to be that easy. Such cosy notions do not square with the reality of a world at war – not in the form of a hot war but of economic confrontations between the United States, Russia and China with the resulting conflagration in energy, commodity and food prices.

Shocks to the global system resulting from pandemic-induced supply interruptions followed by the Ukraine war could persist for years rather than months. What were assumed to be one-off shocks to prices and interest rates now look to be more structural than episodic.

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What is emerging is that key central banks have let the inflation genie out of the bottle by their decisions to allow their economies to “run hot”, aided by fiscal stimulus. Getting it back into the bottle could prove painful for us all.

As International Monetary Fund first deputy managing director Gita Gopinath acknowledged in a presentation to the Jackson Hole gathering, central bankers in advanced economies – for which read chiefly the US Federal Reserve – erred in deciding to “look through” a sudden surge in inflation.

What they saw on the other side was a return to post-pandemic, Ukraine war and supply chain interruption normality where the surge in prices would abate, avoiding the need for aggressive action on interest rates. Financial markets also harboured such illusions.

It hasn’t happened that way. Covid-19 is still very much a reality, supply chains are still disrupted and the Ukraine conflict has made supply and price problems much worse. Inflation is rampant, and it is clear interest rates will chase it upwards, hurting growth in the process.

As Gopinath observed, “several factors appear to be at play. These include the massive size of the global fiscal and monetary stimulus and the speed with which it was deployed.”

This goes to the argument that money is the root of all evil. From when former Fed chairman Alan Greenspan eased policy 20 years ago to soften the blow from the bursting of the dot-com bubble through much larger easing after the 2008 global financial crisis to mega-easing during the pandemic, it’s been a one-way street.

What central bank chiefs and fiscal policymakers failed to foresee was that the handouts designed to ward off recession would go into demand for physical goods because demand for services such as travel and entertainment was constrained by pandemic restrictions.

Arguably, policymakers were deficient in their forward thinking because pandemic-induced production interruptions were obviously going to damage the supply of goods and send prices of consumer goods soaring once demand fuelled by monetary handouts returned.

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Inflation took off to the point where it is flirting with double-digit levels in the US and Europe. It has surpassed that level in Britain and is not far behind in other advanced economies.

Gopinath argues the current period of high inflation “does pose a significant risk that inflation expectations become de-anchored”. The implication is that, without an anchor, they will swing wildly or soar into the blue like a hot-air balloon.

Why did inflation not take off after the global financial crisis given all the money central banks pumped into their economies to stave off recession? The answer is that money ended up in bank reserves rather than going out in the form of bank loans to finance consumption and investment.

Handouts have pushed money into circulation during the pandemic, though, and consumers have responded by spending it. Couple this with supply that cannot match demand – owing to interrupted output and logistical constraints – and inflation is inevitable.

Gita Gopinath, then International Monetary Fund chief economist, speaks at a virtual press briefing during the annual meetings of the IMF and the World Bank in Washington on October 12, 2021. Photo: Xinhua

Gopinath posits that countries have been “running their economies hot” to maintain output and employment – hotter than is justified by potential output and potential employment. It is like pouring high-octane fuel into an engine designed to run more sedately. It tends to overheat.

There is a risk that inflation in the US and other advanced economies could average 4 to 5 per cent in the next five years, or more than double the target rate of 2 per cent, Gopinath suggests. The risk of an “inflation disaster is quite high”.

It’s going to be hard to “look through” this. When stock analysts suggest financial markets have priced in inflation and other risks, one can only conclude they are looking the other way rather than staring into a possible abyss.

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