Last year, the Federal Reserve Board forecast US inflation at 1.7 to 1.9% this year. On their chosen measure it is currently 4.3% - whilst on the more usual CPI measure, inflation is up 5.3% in the year to August. The European Central Bank forecast 2.2% for this year. The Euro area is currently seeing inflation of 3.4% and German inflation is more than 4%. The Bank of England forecast 1.8% inflation for the third quarter of 2021, but it is now at 3.2%. Only Japan still has very low inflation amongst the majors and is struggling to get it up to nearer its 2% target.
So, how has it come to pass that most of the large central banks of the world, with all their forecasting resource and data, have been so wrong? And why are they now wobbling over their errant forecasts? They are now starting to tell us inflation is going higher and will stay higher for longer than last year's forecasts affirmed.
A small band of monetarist economists have been saying for some time that the large amounts of newly created central-bank money spent in the bond markets was bound to cause inflation. This money found its way from bonds to other assets, as the holders of the bonds sold to the central banks and, in turn, bought equities, properties and commodities. There was an immediate and prolonged asset inflation, as you would expect.
Goods and wage inflation make an appearance
The large amounts that governments were able to borrow at record low rates of interest, thanks to central bank friendly policies, circulated in the daily economy as states spent it. This boosted incomes or offset lost income from lockdown. This put upward pressure on items in short supply and on wages in areas of labour with high demand. Asset-price inflation is being followed by goods inflation and some wage inflation as the money circulates. The inflation has not been worse because many individuals and companies have decided to hold a lot more cash than before the crisis, but that could change.
The leading central banks gave up on monetarism some time ago. Most of them do not target the money supply or even comment on it these days. They have gone back to their models based on judgements of capacity and levels of activity relative to the productive abilities of the economy. They would say that the velocity of circulation of money, the amount of use people make of it, varies. They trust that if they create more cash people will use it less, avoiding inflation. It is true that, in the short term, a large expansion in dollars was followed by a reduction in velocity, as many of the dollars were parked in bank accounts. Since then, things have started to stir a bit.
The problem with the sophisticated models they use of the actual economy is that it requires difficult judgements to be made about what is the capacity and what is the output at any given time. These problems become more acute at times of rapid change. The lockdowns shut down large areas of the traditional economy – but provided a mega stimulus to the fast-growing areas such as social media, downloaded entertainment, home computers, laptops, software, broadband, smartphones and online shopping. These areas expanded capacity rapidly but remained under pressure to expand enough. At the same time there was a huge oversupply of office and retail accommodation and many closed catering and underused travel facilities.
Capacity for businesses needing social contact was arguably there to bounce back when rules allowed. Do you say a closed restaurant can easily re-open and is available? What if it cannot hire a replacement chef and decides it can no longer trade because of past losses? What if the bank will not help and it has trouble with rent owing from lockdown? Trying to guess what overall capacity is and how much inflationary pressure new patterns of demand are likely to cause clearly was well beyond the models they were using.
Governments also adopted different definitions of output. If schools were closed, but the state was still paying the full costs of the teachers, some said output fallen. Most assumed some o line and home learning meant no output change. Different decisions created different results in the GDP numbers for both the downturn and the recovery phases. It also affected where they think we are in the inflationary cycle.
The central banks now seem to be losing their confidence that inflation will stay relatively low and the mini spike will be short lived. Faced with the reality of a series of rolling shortages in everything from iron ore to gas, from lumber to semiconductors, they see collectively it has quite an impact on retail inflation.
Whilst some shortages resolve quickly and prices collapse again, others persist. It takes a long time to put in new semiconductor factories or more energy production facilities. They have watched as employers scramble to find enough people to fill lower-paid jobs or certain skilled roles where there is a shortage. They must accept that instead of a large overhang of unemployed and underemployed people from lockdown depressing wages, there are also some clear upward pressures in shortage areas. There may be more than enough people overall, but they do not have the right skills and qualifications or do not wish to take the jobs on offer or do not live in the right place.
All this means the central banks are now likely to tighten more and more quickly than they wished, which, in turn, will slow the recovery more. This will not bring immediate respite to shortages and price rises but will make getting public finances in order more painful going ahead. Slower growth means less tax revenue.
The public and many businesses have cash balances they can spend to try and get things that are in short supply and will pay up to do so. This inflationary round is going to take some fixing as the world seeks to adjust to new levels of demand for everything from cars and homes to energy and food. It takes time to retrain people, put in the right factories and warehouses, and run-down traditional areas stressed by lockdown.
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