Expectations for inflation are on the rise: the implied predictions in the price of inflation-linked US government bonds hit their highest level for 18 months this week. With central banks still flooding the financial system with liquidity, and now the prospect of economies reopening following the rollout of vaccination programmes, investors are right to think there is more potential for an acceleration in price growth next year. Central banks, however, should be more circumspect and guard against any premature withdrawal of support to still-battered economies.
For much of the past year, deflation has been the greater risk for the world. Without sufficient fiscal and monetary policy support, the collapse in consumer and investment spending caused by the pandemic risked pushing the world into a deflationary trap. A drop in economic output below its potential would mean mass unemployment and stockpiles of unsold goods that would weigh on workers’ wages and business revenues. The first job of central bankers should be to resist the disastrous deflation that accompanied the Great Depression in the 1930s.
That risk, however, is now receding. The discovery of seemingly viable vaccines and the resilience of financial markets mean that many of the very worst outcomes for the global economy have become less likely since central bankers initially launched their coronavirus response. The potential re-emergence from the “Great Lockdown” in 2021 has led market participants to turn their attention to the possibility for higher price growth if economies reopen.
Headline inflation measures during the pandemic may also have been misleadingly low, not reflecting the true changes in the cost of living. Prices that have experienced the steepest falls are in categories where consumers have been forced to cut back; cheap airline tickets and package holidays mean little if travel is off the cards. Many categories of goods have been withdrawn altogether — in effect, a price increase. Overall, though, these effects are likely to be minimal: an alternative inflation measure by the European Central Bank that tries to take account of different spending patterns in the pandemic is running only about 0.2 percentage points higher than the official index; wage growth, the biggest source of inflationary pressure, is absent.
Central banks should not, therefore, be overeager in their fight against inflation. The US Federal Reserve and the ECB consistently overestimated the risks of rising prices in the aftermath of the 2008 financial crisis. With a heavily indebted global economy, the costs of deflation are much higher than inflation. Falling prices would mean lower income for businesses while debt burdens and interest rate costs would increase in real terms. There is, by contrast, relatively little to fear from central banks slightly overshooting their inflation targets so long as expectations do not spiral out of control.
Excessive zeal in fighting against inflation would be a big macroeconomic policy mistake. Any resumption in price growth is likely to be modest: the increase in implied inflation predictions in the US may be the highest in more than a year but would still leave it below the Fed’s 2 per cent target. Removing stimulus efforts too early could also end up contributing to greater price pressures. Permanent scarring — a reduction in productivity from lower investment and the debilitating effects of long-term unemployment — would reduce the ability of the economy to provide goods and services cheaply. Vigilance against inflation is sensible, but central bankers should still err on the side of providing too much stimulus rather than too little.
Source: Economy - ft.com
