Global: Why inflation’s being stubborn and what might make it more so

LAGOS (Capital Markets in Africa) – A brief history of monetary and fiscal policy of the twentieth century would go something like this. Monetary policy before the Great Depression of the 1930s was a much more limited endeavour in comparison to its contemporary scope, and it took a back seat to fiscal policy. Under John M. Keynes’ influence of fiscal policy came to be seen as an economic cure-all, relegating monetary policy to the rear until the 1970s’ oil shock. With oil prices and inflation skyrocketing, monetary policy and central bankers started building the reputation (for better or worse) they have today.

As central banks got inflation under control, they gained greater independence and credibility, and Fed chairmen (along with a few more global central bank heads) gradually became household names. The 1990s brought the era of inflation targeting, granting central banks full freedom (and trust) to control inflation. Fiscal profligacy came under fire. Europe probably went furthest in restraining fiscal freedoms by introducing fiscal rules – a wide-ranging set of rules limiting fiscal deficits and debt, on many levels, centrally, federally, locally, depending on the country’s political structure.

It was understandable Europe would do so given the eurozone’s “one monetary but many fiscal policies” framework, but the zeal to restrain fiscal impulse was greater than that. Until the tide turned.

In academic circles, a breaking point in the notion of limiting the role of fiscal policy in demand management came when Reinhart and Rogoff’s influential “This time is different” work – with its finding that any consolidated government debt beyond 90% of GDP limits growth – was revealed as being technically flawed and thus probably invalid. Meanwhile, the European double-dip recession triggered a re-think in policy circles. It took almost a decade (and a global pandemic) for policymakers to turn their back on the previous doctrine of fiscal prudence, but once they did, they did so with a vengeance. The post-Covid recovery came with an unprecedented fiscal support (US recording the highest fiscal deficit for 2020 of 15.6% of GDP but many other advanced economies (AEs) not far behind). True, the global financial crisis (GFC) created high deficits, too, but those were couched with the promise of (in)famous “belt tightening” that duly followed in the decade after the GFC. Moreover, those promises were never aimed at supporting households (or voters).

AE fiscal policy of today is almost diametrically opposed to pre-pandemic doctrines. Not only is “belt tightening” rarely mentioned, but the aim of fiscal spending is also changed. Nowadays, budget deficits are aimed at supporting households rather than bailing out industries. Truth be told, industries also enjoyed fiscal support in the post-pandemic recovery, but the change towards helping households has been crucial.

As a consequence, government debt levels in quite a few AEs have exceeded target rates embodied in earlier fiscal rules (from 60% of GDP that EU’s Maastricht criteria use to the infamous Reinhart-Rogoff 90% of GDP).

Although markets seem fully prepared to shrug off the rising levels of AE public debt, they probably shouldn’t – and not just for the purpose of debt sustainability. Fiscal profligacy aimed at protecting household budgets from shocks, irrespective of income, will slow the pace of decline in inflation. Inflation requires monetary tightening. Monetary tightening can set off a recession which will beg for more fiscal support.

The immediate effect of the shift in fiscal policy stance last time around was a sharp rise in household savings. True, generous budget spending geared towards household balance-sheet support was not the only thing that produced a rise in savings – lockdowns played a role, too. Still, the effect was there, and it helped fuel the 2020 consumer boom and consequent inflation spike that we find ourselves in.

AE household savings are falling but from a very high level
It is thus informative to look at what’s happened with those accumulated savings. Currently, they are starting to shrink among lower-income households in nominal terms, and inflation has made sure that real savings are seeing a dent. Specifically, up to the 60th quantile of the income distribution, US household cash and deposits have seen a fall in real terms. The highest quantiles are still seeing growth in real savings, but that cohort is expected to spend less of it and thus play a smaller role in driving consumer-basket goods prices.

Household savings in Europe are shrinking at a faster rate than in the US, again due to inflation. In real terms, eurozone household sector savings have been falling rapidly since May 2021. While the total level is still above the pre-pandemic point, the declining trend is clear and prolonged. This should be enough to cull inflation, and retail sales will be the first to signal that is happening.

Retail sales are falling, but not too fast
Retail sales in the post-pandemic recovery were anything but usual and expected. Inflation might have looked like a small problem back in 2021 when it first started popping up on the back of exuberant consumer and strained supply chains. Back then, we said absent a significant rise in wages – and thus a wage-price spiral – it could not last. Our reasoning was that absent wage increases, inflation would have consumers run through their accumulated savings, putting a dent in disposable income and nipping rising prices in the bud.

Then came the energy crisis, postponing the expected fall in inflation and raising a possibility of an equilibrium with higher prices at a lower demand. In the short run, you can always achieve an equilibrium with higher inflation and lower consumption – falling demand thus does not automatically stabilise the rise in price if a supply shock (such as an energy price increase) created that price rise in the first place.

A drop in disposable income would eventually bring down inflation, although in the case of the energy crisis it might take longer, as the direct impacts of gas shortages push up the energy component of CPI. But if, as now seems to be the case, there’s fiscal stimulus to cushion the blow to disposable income, inflation will take even longer to fall. Even before significant budget transfers to households have begun, the retail sales picture does not resemble what a central banker seeking to rein in inflation might want to see. The US, in particular, faces an unusually exuberant consumer in this rate-hiking cycle.

Elsewhere in the AEs, things do not look much different. Consumers globally report abysmal confidence – yet they do not appear to be reining in their spending. True, retail spending is clearly past its peak; in Europe, it’s been falling steadily throughout 2022, but it’s still healthy when put in historical perspective. It’s no surprise then that inflation has been so slow to turn.

While this may sound incompatible with generally tight labour markets across AEs, it is likely that we will not see a wage-price spiral in this business cycle. The reasons for that lie in the structural changes of the labour market, resulting in a weakening of labour bargaining power and a rise in marginal attachment in the labour market through zero hours, temporary, and otherwise more flexible work contracts. If this proves to be true in the future (and it looks likely despite a record-high number of labour strikes across AEs), then the traditional wage-price spiral argument is not likely to be useful in providing insight into inflationary conditions.

Producer prices are falling but from a very high level
Supply-side pressures on the other side are waning as well. Producer prices are starting to come down, similar to core inflation, although only slowly and from a very high level.

Not surprisingly, energy is the key culprit, but the good news is that energy prices are also down from their peak. When it comes to commodity prices – another offender behind the PPI rise –those too are now well past their April 2022 peak. Food prices peaked in March and are now significantly lower though still elevated (at about the peak levels seen just before the GFC and again in 2011).

Fiscal policy could check the inflation slowdown
So, while there is compelling evidence that inflation is close to if not past its peak in many economies, there remains huge uncertainty about the speed of the slowdown in inflation.

The real-wages squeeze, slowing retail sales, and falling commodity and producer prices all point to inflation slowing down, albeit slowly. Whether supporting demand with renewed fiscal splurge now is a good idea would seem to be, at best, dubious.

The real threat to fighting inflation now is a mis-calibrated fiscal support (similar to one seen in the pandemic recovery). We see the beginnings of that in the UK energy price cap policy and in less ambitious plans being enacted across Europe. The US at a state level provides household budget support (California seems to take a lead) that has the potential of being mis-calibrated. In a cost-of-living crisis it is hard not to be off in one’s adjustments. But support that is not well attuned can do more harm than good, just as it did two years ago. We have yet to see the full cost of higher inflation (in terms of lost growth), but it would be good if prudent monetary and fiscal policy coordination were to become fashionable once again – at least before we see an AE debt crisis. But it seems that we are not there just yet, and therefore a less orderly return to prudent policy mix will likely provide for a more turbulent macro environment for longer.

Source: Oxford Economics,
Contact author: Tamara Basic Vasiljev, Senior Economist – tvasiljev@oxfordeconomics.com