News that US inflation shot up to 5% (a 13-year high) caught the market and analysts by surprise. The shock was not about the rise but more by the magnitude. Before the release, the Fed had noted cautiously but with some concern the spike in Personal Consumption Expenditure (PCE) which surged to 3.1% in April. The PCE is a better measure of consumer preferences and expected inflation. A debate had been raging amongst economists as to whether the inflation in 2021 was structural or transient.
The Fed insists that this time inflation was driven mainly by disruptions to supply, base year effects and remains transitory. Some others like Larry Summers are of the op-posite view that this was not a binary choice and that the inflation causative factors are a mixed bag. Deutsche Bank the bulge bracket bank broke ranks with consensus economists yesterday in saying that they feared a return to the Paul Volker years when inflation soared followed by high interest rates and a deep recession.
The following article culled from the FT and written by renowned economist Martin Wolf before the data was released is quite pertinent and makes for interesting reading
The Fed risks reacting too slowly if inflation keeps rising-Culled from Financial Times
The world economy is enjoying a vigorous, but divergent, recovery. This is what the World Bank's June Global Economic Prospects is telling us. The main reason for the recovery is the successes of the vaccine programme. The main reason for the divergence is the limitations of the vaccine programme. Some parts of the world economy may become too hot, while others are too cold. So, stay alert. This time is indeed different: the recession was caused not by the need to curb excessive inflation, nor by an oil shock, nor by a financial crisis, but by a virus. Now, with the success of the vaccine programmes, the world is enjoying among the strongest recoveries from recession since 1945.
That is the good news. The bad news is how uneven the recovery will be. According to Global Economic Prospects, 94 per cent of high-income countries will regain prerecession gross domestic product per head within two years. This would be the highest share in so brief a period after any recession since the Second World War. But the proportion of emerging and developing countries expected to achieve such an outcome this time is forecast to be 40 per cent. That would be the lowest share after any post-war recession.
The relative success of the high-income countries is due to the scale of their fiscal and monetary responses and their vaccine rollouts. Emerging and developing countries are far behind in all these respects. Quantitative easing averaged 15 per cent of GDP in high-income countries, against 3 per cent in emerging and developing countries. Fiscal support averaged 17 per cent in high-income countries, against 5 per cent in emerging and developing countries. Even so, half of all low-income countries are in debt distress. According to World Bank president David Malpass, the "pandemic not only reversed gains in global poverty reduction for the first time in a generation but also deepened the challenges of food insecurity and rising food prices for many millions of people". The UK's decision to cut its foreign aid budget is breathtakingly ill-timed.
Given all this, the most important decisionfor leaders of the G7 high-income countries to take this week is to fund a sharp acceleration in the supply and distribution of vaccines. This will also benefit donors. The pandemic must be stopped everywhere if people are to be truly safe anywhere.
Among high-income economies, the most important locomotive of growth is the US, with its highly aggressive monetary and fiscal policies. The budget proposal of Joe Biden forecasts federal deficits of 16.7 per cent of GDP this fiscal year (to end-September) and 7.8 per cent next year. Meanwhile, most members of the Federal Reserve's board expect interest rates to stay near zero even until the end of 2023. These policies are bringing big benefits. But how risky are they?
This has become much debated. It is also not a purely local matter. If the Fed has to raise rates sharply, it is likely to cause another sharp recession in the US. That would not only be bad for Ameri-ca, but also be bad for the world, in-cluding vulnerable developing countries.
It is this context that makes the debate on inflation particularly significant. Stephen Roach, who worked at the Fed in the 1970s, has recalled Arthur Burns, the Fed chair who let the inflation ge-nie out of the bottle in the early 1970s. If that were to be repeated, it would be costly for almost everyone. But is that outcome actually likely? The answer is "yes" - not because of what has al-ready happened, but because of the Fed's commitments.
The rise in inflation we are now seeing might be both modest and temporary and not affect inflationary expecta-tions, as the Fed believes. But the Fed has locked itself into responding too slowly, especially given the fiscal ex-pansion. This is because, in the words of Richard Clarida, vice-chair, "we ex-pect it will be appropriate to keep the federal funds rate in the current 0 to 25 basis point target range until inflation has reached 2 per cent (on an annual basis) and labour market conditions have reached levels consistent with the [Federal Open market] Committee's as-sessment of maximum employment".
This is "outcome-based" as opposed to "forecast-based" policy. What in layman's language does it mean? It means that the Fed will persist with ultra-loose monetary policy until employment has already reached its (unknowable) "maximum". Given the lags between policy and outcomes, this guarantees overshooting. By the time the economy finally reaches the point when the Fed starts to tighten, it will be smoking hot (at "maximum employment") and, inevitably, getting hotter.
That is what happened in the 1970s. In that case, the necessary disinflation was postponed until Paul Volcker took over in 1979. The experience was brutal. Given the inevitable lags between tightening and bringing inflation under control, the costs are again likely to be severe. That would not matter to the US alone. Remember: the Volcker shock triggered the Latin American debt crisis.This time, there is much more debt around almost everywhere. A severe monetary tightening would create even more devastation than then.
Getting the world as a whole out of the pandemic crisis is far from a done deal. Much more still needs to be done on that. Furthermore, the new approach to monetary policy of the world's most important central bank risks serious overshooting. By responding only to outcomes, it is nigh on certain to react too slowly. It is possible that this will not matter, because expectations remain well anchored, whatever happens. I pray this will be case. The alternative does not bear much thinking about.