Commentary on Political Economy

Wednesday, 24 February 2021


China made it easier for the Fed to fight inflation, but those days are gone

The Federal Reserve building in D.C. on Feb. 19.
The Federal Reserve building in D.C. on Feb. 19. (Samuel Corum/Bloomberg)
Feb. 24, 2021 at 5:30 a.m. GMT+8

Remember inflation? If you, like most Americans, were born after 1981, the answer must be “no.” Annual growth in personal consumption expenditures, the Federal Reserve’s preferred indicator of the inflation rate, hit a postwar peak of 10.8 percent in 1980 and last exceeded 5 percent in 1982. It last exceeded 4 percent in 1990. It has met or exceeded the Fed’s current target — 2 percent — just twice in the past decade.

Financial markets do not foresee an inflation comeback. A Fed index of inflation-sensitive bonds suggests investors expect inflation of 1.97 percent, a smidgen below the Fed’s target, five years from now. That expectation is up considerably from last March, at the onset of the coronavirus crisis, but still below where it was three years ago. Meanwhile, major industrial economies remain burdened by idle capacity and unemployment, which are usually deflationary.

But what if structural trends, below the surface of financial markets, are pushing the global economy back toward an inflationary environment similar to the one that prevailed during the 1960s and 1970s?

That is the thesis of a provocative new book by Charles Goodhart and Manoj Pradhan, “The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival,” whose mouthful of a title belies the elegance of its argument.

The authors, British economists, contend that the fundamental cause of low inflation for the past several decades was the rise of China, with its vast population of low-wage workers, and that country’s integration into global commerce.

Coupled with the smaller but similar opening of Eastern Europe and the former Soviet Union, this delivered “the largest ever upwards supply shock to the availability of labor,” undermining the power of U.S. and other developed-country workers to demand higher wages. Thus ended a relative golden age for income equality, but also the inflationary wage-price spiral about which Western academia and media obsessed in the 1970s — and that hardly anyone remembers today.

During the time of global labor-force expansion, the inflation-fighting job of central banks became easier, even at low rates of unemployment previously thought incompatible with price stability.

Now, however, China’s working-age population is rapidly shrinking, as are those of many advanced industrial economies, which portends relative labor scarcity and a corresponding increase in worker bargaining power. While higher wages may mean less inequality, Goodhart and Pradhan argue, they also threaten to rekindle the wage-price spiral.

To be sure, the Fed has tools — dialing back its bond purchases, raising interest rates — to deal with unexpected inflation, if and when it happens.

What’s original, and alarming, about Goodhart and Pradhan’s argument is their view that these tools may have lost efficacy.

Both corporations and the federal government have accumulated huge debts on the basis of low interest rates, the authors note. Importantly, much of this leverage represents federal obligations to a burgeoning elderly population, which cannot be reduced for both political and moral reasons.

Consequently, it would be much harder than many believe for the Fed to impose tighter financial conditions without triggering a crisis possibly even more disruptive than the 10 percent unemployment then-Chairman Paul Volcker induced to tame inflation in the early 1980s. “The path between inflation on the one hand and deflation on the other becomes narrower and narrower,” Goodhart told me in an interview.

If inflation does accelerate, the foreseeable consequences would not all be negative. Student debt would decline in real terms, for example, with no need for government to cancel it.

As those who lived through the late 1970s know, though, high inflation would wreak havoc across the economy, doing particular damage to institutions that reward middle-class thrift: homeownership, savings accounts, pensions, insurance.

The next-best thing to personal memory of that period is former Post columnist Robert Samuelson’s book “The Great Inflation and Its Aftermath: The Past and Future of American Affluence.” Samuelson vividly describes how price increases for everything from groceries to dry cleaning — “like a rain that never stopped” — eroded ordinary people’s ability to plan and, ultimately, their confidence.

The ensuing political upheaval eventually made Jimmy Carter a one-term president and paved the way for the Reagan Revolution. And that was in a period of relative bipartisan consensus, with no cable TV news or Twitter to magnify the public’s fury at every price hike.

For now, there seems little chance that price stability will disappear as disastrously as it did half a century ago. The urgent priority is recovery, the benefits of which probably exceed the risks of federal borrowing and monetary expansion.

Goodhart and Pradhan remind us, however, of the potential limits to that strategy and of the need to start planning for the next chapter in economic history, bearing in mind how dimly we understand the future or, indeed, the recent past.

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