Monetary policy is not a cure-all for the issues surrounding inflation. During the summer, CPI inflation in the US hit a 40-year high, much higher than the market anticipated. US Secretary of the Treasury Janet Yellen believed the problem was “transitory.” She thought it resulted from base-level effects and supply chain kinks which, once ironed-out, would dissipate. Yellen later admitted that she had been mistaken in understanding how entrenched inflation had become. Belatedly, the US Federal Reserve embarked on a path of interest rate increases and unwinding quantitative easing to tackle the problem. Indeed, inflation is seen to be a global problem afflicting many countries such as the UK and the western European economies. Bank of England governor Andrew Bailey and ECB President Christine Lagarde have both laid-out paths to terminate quantitative easing and to hike rates.
But is monetary policy the right tool to deal with the current bout of inflation? Price spikes caused much of the inflation we are experiencing now. There were sharp increases in food, energy, and all goods and services dependent upon energy. The war in Ukraine caused some of that. This inflation is also, I suspect, due to the switch of consumer demand from services to goods experienced during the pandemic. That demand change may prove to be permanent. Supply chains have been unable to adjust quickly enough to meet the new demands, in turn caused by lingering effects of the pandemic and by the war in Ukraine.
Inflation such as this, caused by both supply and demand shocks, cannot be cured by monetary policy. Raising rates will not increase supplies of oil, natural gas, or food. It will not help to unkink supply chains. Central bank rate hikes will, therefore, not prove to be effective in curbing short-term inflation. Having misdiagnosed the problem, it is likely central banks will push interest rates too far. That will likely result in a collapse of financial asset prices — and damage to the real economy. A recession is all but inevitable at this point. One likely result? Stagflation — persistent inflation in the face of a weak economy. Eventually the recession will curb demand which, in turn, will curb inflation. But that happens only after a painful journey during which unemployment will certainly rise markedly. The idea that central banks will be able to engineer a soft-landing for the economy is delusional.
This is not to suggest that interest rates should have been kept close to zero and quantitative easing maintained. Loose monetary policy, conventional and unconventional, has inflated asset prices to unsustainable levels, exacerbating wealth disparity and damaging social cohesion. Rates were set far too low for far too long, driving an asset inflation bubble and increased wealth disparity. Now raising rates will do nothing to ameliorate energy shortages and supply chain disruptions causing current inflation.
It might have been better, too, had the resulting proliferation of zombie companies been allowed to fail. Schumpeterian creative destruction is an important element of a healthy and high-productivity capitalist economy. Investopedia.com says:
The term creative destruction was first coined by Austrian economist Joseph Schumpeter in 1942. Schumpeter characterized creative destruction as innovations in the manufacturing process that increase productivity, describing it as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”
The proliferation of zombies, companies resurrected by multiple bailouts, is probably the reason levels of productivity have fallen so much. The zombies were probably not around long enough to innovate.
The government needed to do a lot on the fiscal side to address structural issues facing the economy. In particular, they had to address huge growth in government indebtedness, now exceeding 137% of GDP in the US. That hasn’t happened, and the political will does not appear to exist. In Part 2, I will discuss government indebtedness, the major drag on US economic growth .
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This article was edited by Maryan Pelland]
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Paul Shotton is the Chairman of White Diamond Risk Advisory, a bespoke company providing advisory services to CEOs, boards, and entrepreneurs. He serves as an advisor to Adamcare, Belay Associates, Brighterwatts, Eleven Canterbury, and Piton Dynamics. Paul gained his BA, MA, and Ph.D. in physics from the University of Oxford and began his career as…
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