Spare the bear: the inflation debate that should be happening

If there were no trade-off between inflation and growth, central banking would be easy. Managing the trade-off between the two – and being forward-looking about it – used to be a core tenet of central bank policymaking. But that’s absent from the current debate, precisely when it’s needed more than ever.

Why more than ever? We’re in a new regime where that trade-off between growth and inflation is even sharper – largely due to production constraints in the economy, as we explained in a previous post. We don’t see those production constraints easing quickly. This puts central banks between a rock and a hard place. Yet, while they have started to acknowledge the sharper trade-off, they continue to focus solely on managing the inflation side of it. Federal Reserve Chair Powell emphasized that the “responsibility to deliver price stability is unconditional.”ⁱⁱ Isabel Schnabel, Executive Board member of the European Central Bank (ECB), said “regaining and preserving trust requires us to bring inflation back to target quickly.”ⁱⁱⁱ

But they are mostly silent about the collateral damage. For hikes to reduce inflation, they need to hurt growth. There is no way around this. How much they will hurt needs to be part of the equation. We estimate it would require a deep recession in the U.S., with around as much as a 2% hit to growth in the U.S. and 3 million more unemployed, and an even deeper recession in Europe.

Implicitly, central banks seem to believe that pain is trumped by the risk of inflation expectations de-anchoring – and that justifies aggressive rate hikes to “kill the bear.” Indeed, it would be justified if inflation expectations were unanchored. And it’s true that no one really has a good handle on how inflation expectations work: they’re anchored until they’re not. But contrary to when Paul Volcker took office as Fed chair in 1979, they remain anchored now. Unlike Volcker, they still have a stock of credibility to draw on.

By focusing solely on the theoretical de-anchoring of inflation expectations and ignoring the very real growth costs, both the Fed and the ECB are swerving a crucial debate that needs to be had: where should policymakers land on the inflation/growth trade-off and what is the appropriate speed at which inflation should come back down to the 2% target?

They each swerve that debate in different ways. The ECB argues for “robust control” – avoiding inflation expectations de-anchoring at all costs, irrespective of how likely this outcome is. By that logic, you would stay in your house for fear of being hit by a car if you go out. The Fed argues it can bring inflation quickly back down to 2% without a recession. Wishful thinking, by our estimates. In the UK, this manifests itself with authorities working at cross purposes: the Bank of England sees a deep recession as necessary to bring inflation down, while the government is trying to spend its way out of it.

Central banks could reduce the hit to growth by taking longer to bring inflation back to target. That would give the economy a chance to find a new equilibrium as production capacity slowly recovers (see the An alternative path for growth chart). The cost of that choice is inflation staying somewhat higher for longer (see the pink line in A slower fall in inflation to protect growth chart). But if inflation expectations remain anchored, that would overall be a better outcome for society.

It has long been recognized that policymaker incentives might not align with the best outcome for society. A prime example is the historical temptation to overstimulate the economy in the short term for political gains.^iv We could be seeing the opposite now. From the personal perspective of central bankers, the worst possible outcome is to be the next Arthur Burns. He went down in history as the man who allowed U.S. inflation to reach nearly 15% and inflation expectations to surge. From that perspective, causing a recession is not as bad an outcome, particularly if there is a chance to blame it on something else or spin it as a “Volcker moment” – Volcker successfully got inflation back under control by ramping up interest rates to an eyewatering 22%. But it’s not necessarily the best outcome for society.

That’s why a serious forward-looking debate needs to be had about the trade-off in its entirety. Killing the economy now would be an unnecessary step if inflation expectations remain anchored. But it could also prove less costly than what would be needed if inflation expectations did de-anchor.

This is the most difficult economic environment to navigate in half a century – even more than the financial crisis. The idea it is as simple as asserting “we will do whatever it takes” to bring inflation back down quickly is mistaken. There is no desirable outcome at this stage – the question is which is the least bad.

Ultimately, Knut was saved by a public outcry. Now our economies face a similar fate as Knut, but there is no outcry. It’s time for a proper debate.