Taming inflation

The US Fed might be able to get the job done at a lower cost than is widely feared

There is great inflation around us across the world. How hard will it be to wrestle this to the ground? In some ways, it appears that a bloody-minded slog is impending. There is much uncertainty and dispersion of views on how this will play out. But there is logic in favour of a cautiously and less gloomy scenario.

The pandemic kicked off a strong macro policy response in developing markets (DMs). The fiscal policy played at World War 2-levels in the US, encouraged by what was then the impending election in November 2020. The central banks in DMs cut rates sharply, and reopened the toolkit of unconventional monetary policy developed in 2008. With the benefit of hindsight, we know that these responses were overdone. Matters were made worse by the pandemic and war-related disruptions of the supply chain. All these forces came together and kicked off an inflation that is comparable with the one witnessed in 1970s.

India was a great beneficiary of expansionary DM macro policy as this ignited an export boom here. In similar fashion, the Indian macro/finance environment is now being reshaped by the global inflation and the DM monetary policy response. We in India need to understand this situation.

Monetary policy is the task of controlling the short-term interest rate of the economy to deliver price stability in the long run. We should express the short-term interest rate in real terms. For instance, in India, when the short rate is 5 per cent and (expected) inflation is at 8 per cent, the short rate is -3 per cent in real terms. The policy rate should generally be positive in real terms to fight inflation.

A nice tool of monetary economics lies in thinking about what happens when expected inflation changes. Suppose expected inflation goes up by 100 basis points (bp). If the short rate goes up by only 50 bp, then in effect, the real rate has gone down. This should generally not be the case. This idea is called ‘Taylor principle’. Monetary policy must respond by more than the change in (expected) inflation. When inflation drops by 100 bp, monetary policy must respond with a cut of perhaps 150 bp, and vice versa.

Illustration: Ajay Mohanty

With the benefit of hindsight, many central banks played this wrong in recent years. Expected inflation rose, but the monetary policy response was not commensurate. The economy overheated and inflation rose, but real rates fell, which further stimulated the economy. Economic agents watched this spectacle, and concluded that central banks were not serious about inflation. Their wage-setting and price-setting behaviour changed, which fuelled inflation.

This is why the US Fed had to engage in shock and awe in recent months. It is trying to claw back to a real rate that is positive, and more primal — a set of months in which the increase of the rate is bigger than the increase of expected inflation — so the real rate goes up. It is trying to claw back its credibility, to get back to a point where there is no doubt about the Fed’s objective.

Could this be a bloody-minded slog, like an artillery war in the eastern Ukraine, where much misery is induced? Monetary policy only acts over long time horizons, and the impact on inflation plays through over 12-18 months. Will the world economy be driven into recession as a side effect of conquering inflation? There are three arguments in favour of a more optimistic reading.

The key thing is how the public sees the Fed: The extent to which the Fed is seen as credibly focused on getting US inflation to 2 per cent with no extraneous considerations. For a while, it seemed that this was not the case, with words and deeds by the Fed which appeared to stray from the inflation target. That period is decisively behind us. The Fed is back in the game as a normal mature central bank, with no uncertainty about its objective, a 2 per cent inflation target. The recent fluff about climate change or women's employment has been discarded. From 1994 onwards, the US Fed has had no exchange rate objectives.

This knowledge — this ‘mere knowledge’ — in the minds of workers and firms helps to stabilise inflation. Individuals make decisions on wage and price, and once there is trust in the objective of the Fed, these decisions will change so as to bring down inflation. If done right, monetary policy is a mind job and more cruelty is promised than inflicted. Institutional credibility partly substitutes for pain. This is not just a theoretical construct: There are episodes in history (e.g. Israel in 1985) where the pain required for reducing inflation was remarkably low through strategies that rearranged expectations of the people.

What about the supply disruption? The market economy is a self-organising and self-healing system, and from January 2020 onwards, firms have been modifying their behaviour. As an example, the Baltic Exchange Dry Index, which measures the cost of shipping raw materials, rapidly got back from the peak of 5,500 in September 2021 to normal values by December 2021.

The Covid supply chain disruption of 2020 has dragged on much more than expected owing to new developments in China and Russia. For the rest, the price system ceaselessly diagnoses and solves the problems of production. Barring big new shocks on the scale of Chinese Zero-Covid Policy or Russia's invasion of Ukraine, the reconfiguration of global production is well underway.

Finally, DM fiscal policy tightening is helping. The pedal had been floored in the pandemic, but in the latest quarters, we are at more normal values. This reduces the inflationary pressure.

What extreme actions will the US Fed now take? When will macroeconomic stability (i.e. 2 per cent inflation) return, after which normal economic growth can recommence? It is true the Fed may have to do harsh things in order to get the job done. Three arguments — the power of a credible inflation-targeting regime, the healing of supply chains, and fiscal normalisation — suggest that restoration of stability could be achieved at a lower cost than is widely feared. 

The writer is a researcher at XKDR Forum