The years that followed saw a marked overhaul of monetary policy, with many central banks gaining independence from governments and making inflation targeting their primary objective. Coupled with the peak era of globalization and productivity gains from the internet revolution, this led inflation to stay low and steady from the mid-1990s. Following the Global Financial Crisis (GFC), price pressures dimmed further still, consistently undershooting official targets. The overarching concern in central bank boardrooms from Washington to Frankfurt became too little inflation, not too much. For the majority of citizens in developed countries, inflation ceased to form a relevant part of their decision-making process, becoming a phenomenon to be thought of in fairly benign terms—if at all.
However, the current heady cocktail of fiscal stimulus, expansive monetary policy, supply constraints and the lifting of Covid-19 lockdowns is now leading to a significant rebound in inflation—particularly in the United States. Financial markets have taken notice, with ten-year U.S. Treasury yields more than doubling since late last year. Following years of subdued prices, for some this new paradigm is to be welcomed. But is there a risk of inflation getting out of control? And once the sugar rush of fiscal stimulus wears off and supply bottlenecks ease, has the long-term inflation outlook really changed?
To answer these questions, it helps to first take a closer look at how we got to where we are today. It was in the 1970s that inflation finally became a problem for governments. The decade began inauspiciously: In a bid to boost living standards and protect the U.S. dollar from speculative attacks, then-President Nixon announced tariffs on imports, wage and price controls, and the unilateral suspension of the dollar’s convertibility into gold. Given the dollar was the linchpin of the Bretton Woods system of fixed exchange rates in place since WW2, this last move in particular sent shockwaves through the global financial system. Subsequent attempts to salvage Bretton Woods failed: By 1973, major currencies were free-floating, and the U.S. dollar had plummeted in value.
Around the same time, OPEC announced a crippling embargo which saw the price of oil quadruple. This sparked an energy crisis in the West and spurned a host of coping measures, from the weighty—fuel rationing and controlled power cuts to investment in alternative energy—to the whimsical, such as ending TV broadcasts early, or not playing football matches under floodlights.
These events were set against a backdrop of powerful labor unions and crude stop-go economic policies which rested on the belief that price pressures were inevitable in the pursuit of full employment. The upshot of all these factors was surging inflation.
But at the same time, economic activity and labor markets were weak. The Philipps Curve, which posited the inverse relationship between inflation and unemployment and had served as a cornerstone of the prevailing economic narrative for decades, appeared to have broken down.
With the economics profession going through a period of soul searching, the ideas of one Milton Friedman—a professor at the University of Chicago and long regarded as something of an eccentric—grew seductive. Friedman argued that the apparent ability of governments to top up their economies at the cost of a little inflation was an illusion: Authorities should instead focus on controlling the money supply and establishing a stable, rule-based framework for monetary policy. Famously, he stated that “Inflation is always and everywhere a monetary phenomenon”.
These ideas were soon put into practice. In 1979, Paul Volcker became chairman of the U.S. Federal Reserve, immediately jacking up the Federal Funds Rate to 20%. The economic medicine sparked a painful recession, but Volcker achieved his primary aim: Inflation fell from the double digits to around 3% by 1983. On the other side of the Atlantic, newly appointed UK Prime Minister Margaret Thatcher embarked on her own monetarist experiment, with similar results.
The seeds had been sown for central bank policy as we recognize it today. But inflation remained volatile, and an overarching framework which codified this new approach into law—taming price pressures in the process—was still lacking. That would have to wait several more years, and would come from an unsuspected corner of the world
- The Goldilocks period
Don Brash seemed like an unlikely man to start a revolution. Born in the small New Zealand town of Wanganui, he had worked as managing director of the New Zealand Kiwifruit Authority before becoming governor of the country’s central bank (RBNZ) in 1988.
Shortly into his tenure, against a backdrop of lackluster growth and sustained high inflation, parliament approved the Reserve Bank Act. The news was met with little pomp or fanfare, and did not travel far beyond the shores of the small island nation of 3 million people. The provisions were—by today’s standards—exceedingly dull: The Act set the central bank the objective of price stability, directed the government and the bank to agree on a formal inflation target, and provided the bank with the operational independence to meet it.
However, this seemingly innocuous event marked an inflection point in the history of monetary policy. For the first time, a central bank had taken the radical step of simply stating what inflation rate it was aiming to achieve. By all accounts, the policy was a resounding success: Under the stewardship of Mr. Brash, by the early 1990s the RBNZ had guided inflation to around 2%, as the expectations of consumers and firms became anchored around the new target. The governor travelled abroad to espouse the benefits of this new approach to fellow central bankers.
Other countries were quick to follow New Zealand’s lead. In the years that followed, formal inflation targeting, along with greater institutional independence for central banks, became the norm in developed and emerging markets alike. Decision-making grew increasingly sophisticated and fine-tuned. In short, monetary policy had finally come of age.
This was a key cause of the Great Moderation—a period of mild and stable inflation which would last until the late 2000s. “The 1970s, the period of highest volatility in both output and inflation, was also a period in which monetary policy performed quite poorly, relative to both earlier and later periods,” remarked Ben Bernanke, then-governor of the Federal Reserve, in 2004. “Few disagree that monetary policy has played a large part in stabilizing inflation [since then].”
Other factors helped. The digital revolution was in full swing as the internet went mainstream, bringing welcome productivity gains which reduced inflationary pressures. Globalization was at its zenith, propelled by the collapse of the Soviet Union and China’s accession to the WTO, which spurred low-cost manufacturing and maximized economic efficiency. Policymakers could have been forgiven for thinking that inflation would continue to run neither too hot nor too cold for the foreseeable future. And they may have been right—had it not been for the GFC.
- Missing in action
In November 2008, the global economy was in meltdown. Access to credit was drying up, formerly reputable banks were going under, and economic sentiment was collapsing, as the crisis which initially stemmed from risky lending in the U.S. subprime mortgage market spread around the world. Officials at the Federal Reserve were shellshocked: Attempts to stabilize the ship through textbook rate cuts and credit lines to firms had proved insufficient, and economic indicators were moving further into the red.
With its back against the wall, and out of traditional policy ammunition, the Bank took a bold step into the unknown, announcing it would buy USD 600 billion in mortgage-backed securities in a bid to push down yields. A few months later, the program was expanded by an additional USD 1 trillion, with the scope extended to purchases of Treasury bonds. Many other central banks launched their own asset purchase schemes. “Quantitative easing” (QE)—then a niche idea only previously tested with mixed results by the Bank of Japan—had suddenly gone mainstream.
Many people at the time voiced concerns that such a huge expansion of the monetary base would inevitably generate excess inflation as the global economy moved into recovery mode. But the opposite happened: In the decade following the GFC, inflation often undershot central bank targets—particularly in Europe. QE programs, initially envisioned as an emergency measure, became a permanent fixture of the economic landscape in a bid to prop up prices.
The potential causes for the lack of inflation are manifold. The first is that lots of the additional liquidity injected into markets simply remained parked in the banking system in the form of excess reserves, rather than circulating through the economy. The U.S. is a case in point: Despite the monetary base tripling in the wake of the GFC, M2 money supply only rose modestly.
Weak demand is another likely factor. With widespread fears over the destabilizing effect of high public debt, austerity economics was all the rage, and institutions such as the IMF prescribed deep spending cuts as a surefire route back to economic health. Many governments pulled the fiscal rug from under their economies before they had fully recovered.
And structural economic changes, such as an increasingly skewed income distribution, the emergence of the sharing economy and the rise of online shopping could also have played a role in depressing price pressures, through a mixture of dampened spending and improved supply
- The Covid-19 shock
Initially, the arrival of Covid-19 in early 2020 further entrenched this deflationary trend, with lockdowns sucking demand out of the global economy, more than offsetting upward price pressures from disruptions to supply chains and currency weakening.
But this effect is now going into reverse: As vaccines are rolled out, restrictions are eased, and commodity prices recover, global inflation is rising swiftly in many countries, and is projected to average markedly higher in 2021 compared to 2020. Moreover, following years of subdued price pressures, developed country central banks are likely to remain passive in the face of higher short-term inflation, keeping rates at record-low levels.
In the U.S., this favorable backdrop for prices is further enhanced by turbocharged consumer spending, thanks to generous government handouts under President Biden’s 1.9 trillion stimulus plan. Simultaneously, Federal Reserve Governor Jerome Powell has been at pains to make clear the bank will keep its pedal to the metal for the time being, as it actively aims for inflation to overshoot under the new average inflation targeting regime introduced last year. For the first time in a long time, the word “overheating” has crept into the market lexicon when talking about the outlook for the U.S. economy.
Risks appear skewed to the upside. Current price increases, coupled with difficulty sourcing workers, could spur faster wage hikes, feeding into even higher prices down the road. And expectations could become unmoored if inflation remains above-target for a prolonged period.
The institutions we poll still regard this scenario as unlikely; they expect U.S. inflation to peak in Q2 of this year and decline thereafter. Yet inflation is still forecast to remain above the Fed’s 2% target over the next several years, suggesting a lingering impact of current pressures. Gregory Daco, chief economist at Oxford Economics, sums up the view of our panelists: “The pickup in inflation is neither purely “transitory” nor the start of an upward spiral.”
And what of the longer-term impact of the coronavirus pandemic on the inflation outlook? Here, the jury is still out. On one hand, damage to productive capacity, higher spending and taxes, and more fragmented supply chains as countries look to reshore key manufacturing capabilities could fan the flames of inflation in the years ahead. Yet on the other hand, greater digitalization and public investment have the potential to provide a meaningful boost to productivity, dampening price pressures.
On balance, inflation is likely to average higher this decade than last. But for most countries, today’s long-term inflation forecasts are virtually unchanged from our pre-Covid-19 projections, suggesting the virus’s impact—if it exists at all—will be at the margin. The underlying structural factors which could push up prices in the years ahead—such as protectionism, environmentalism, population ageing and China’s shift away from producing cheap manufactured goods—all predated the pandemic. And while the U.S. is a high-profile exception (U.S. inflation projections to 2025 have risen compared to before the pandemic), this probably owes more to the Federal Reserve’s shift to average inflation targeting than the pandemic itself.
In any case, there should be no return to the dog days of the 1970s. Today’s crop of central bankers are too wily, and the credibility they have built up in recent decades too great, for that to happen. A large upward shift in the inflation outlook would require an explicit and dramatic change to the monetary framework, or for authorities to ditch their inflation targets altogether—unlikely barring an unforeseen shake-up of the political climate. As such, Ronald Reagan’s hair-raising description of inflation is unlikely to gain a new lease of life in the years ahead; and for that we can all be thankful.