key: cord-0076836-c24zobzq
authors: Eichengreen, Barry
title: European Inflation in an American Mirror
date: 2022-04-08
journal: Intereconomics
DOI: 10.1007/s10272-022-1033-x
sha: a33681e7e2d5a60ad7641517d93873b5301df3ee
doc_id: 76836
cord_uid: c24zobzq

In these highly uncertain times, flexibility has value.

The Fed, or more specifi cally those responsible for its policies, were seen as unlikely to act because they lacked a coherent model of the connections between central bank policy and infl ation. In the 1950s and fi rst half of the 1960s, the anchor for policy, such as it was, was the Bretton Woods international monetary system. Under Bretton Woods, the U.S. pegged the dollar price of gold at $35 an ounce and stood ready to pay out gold for dollars on demand to foreign central Even before Russia's invasion of Ukraine, it had become painfully obvious that the United States had an infl ation problem. Now Mr. Putin's war has added fuel to the fi re by pushing up energy and food prices and creating additional supply-chain disruptions. It is clear that the Federal Reserve has fallen behind the curve, having failed to anticipate the magnitude of the infl ation in the pipeline. What is not clear is whether and how it will now catch up. Nor is it clear whether other central banks, notably the European Central Bank (ECB), will avoid committing the same unforced error.

The numbers for the U.S. are not good. Annual infl ation accelerated to 7.9% in February, the highest level since early 1982, propelled by rising prices of energy, shelter, food and motor vehicles. Alarmed observers point to parallels with the 1970s, when commodity prices shot up, the Fed fell behind the curve, and infl ation expectations became unmoored. Consumers, producers and workers all expected prices to keep rising at the same or even at an accelerating pace. Accordingly, workers adjusted their wage demands, consumers their spending patterns, and businesses their prices, unleashing what became a self-fulfi lling infl ationary spiral.

The current situation is diff erent. Infl ation expectations, for the moment, remain at least tenuously anchored. The University of Michigan Survey of Consumers for February confi rms that respondents expect infl ation to approach 5% over the coming year, but then to fall back to just above 2% in the subsequent four years, consistent with the Fed's infl ation target. The Federal Reserve Bank of New York's Survey of Consumer Expectations for the same month similarly shows that respondents expect infl ation to run at 6% over the coming year but to then fall back to 3.8% over a three-year-ahead horizon. As of mid-March, the break-even infl ation rate derived from fi veyear Treasury infl ation-indexed securities shows expectations of infl ation averaging around 3.5% over the next fi ve yearsmeaning that infl ation between 2023 and 2026 is expected to Forum infl ation approached 6% already in 1970, even before the collapse of Bretton Woods.

Removing the exchange rate anchor would not have made a diff erence had the Fed possessed a coherent theory connecting monetary policy with infl ation. Unfortunately, it did not. The closest thing to a theory was Chairman Arthur Burns' view that monetary policy did not matter. Burns saw infl ation as caused, variously, by the excessive wage demands of unions, price increases by fi rms with market power, poor harvests and high oil prices, none of which monetary policy could directly control. He recognized a link between excessive budget defi cits and infl ation, but not one that a change in monetary policy could off set. In his academic career as a business cycle researcher, Burns had portrayed output and price fl uctuations as shaped by institutional arrangements in product and labor markets, not by central bank policy (Burns and Mitchell, 1946) . He brought to his tenure at the Federal Reserve this same focus on arrangements in labor, product, energy and commodity markets.

The next Fed chair, G. William Miller, lacked Burns' academic credentials and was not inclined to challenge the views of his illustrious predecessor. Eventually, Paul Volcker would have something to say about this, but not until the 1980s. Even then, it took Volcker time, and multiple tries, to alter expectations and fi rmly place the anchor. 7

The rocky road ahead Circumstances today are diff erent. Federal Reserve offi cials understand that, in all but the most exceptional circumstances, namely those of a liquidity trap, monetary policy and infl ation are intertwined. They possess a coherent policy framework, namely average infl ation targeting.

But circumstances today are also diff erent from the 1980s, when Paul Volcker crushed infl ation. The Powell Fed is strongly committed to not disturbing fi nancial markets. It has communicated its intention of raising its policy interest rate in 25 basis point increments, presumably seven times between March and December of 2022, corresponding to its seven regularly scheduled Federal Open Market Committee meet-7 In fact, contrary to legend, Volcker's early eff orts to tame infl ation were unsuccessful. Infl ation expectations as measured by the Michigan survey continued to hover in the 9%-10% range following the October 6, 1979 press conference where Volcker announced the Fed's new operating strategy. When the Fed then paused its tightening cycle in late 1979 in response to a softening economy and fears of a recession, long-term interest rates rose, contrary to what one would expect given the impending recession and indicative of expectations of accelerating infl ation. Progress on the infl ation problem would have to wait. As late as the end of 1980, infl ation expectations according to the Michigan survey were still as high as in late 1979, when Volcker's anti-infl ation initiatives were just getting underway.

banks and governments. 2 The Fed understood that excessive infl ation made possible by lax central bank policy might jeopardize this commitment. If U.S. interest rates were too low, capital would fl ow out of the country, gold would be lost to foreign entities acquiring dollars, and U.S. rates would have to be raised. If U.S. spending was too strong, imports would surge, gold would again be lost, and the Fed would be forced to rein in demand.

The Federal Reserve was not targeting infl ation. It was not targeting high employment. Rather, it was seeking to preserve U.S. gold reserves and to defend the dollar's Bretton Woods peg. The minutes of the Federal Open Market Committee document these concerns (Bordo and Eichengreen, 2013) . The value attached by the Fed to the stability of the exchange rate was public knowledge, by virtue of statements by members of the Board of Governors. Hence, if demand increased, fueling infl ation and causing the balance of payments to deteriorate, there was an awareness that the Fed would tighten, which in turn limited the infl ationary consequences. Expectations were anchored by the Fed's commitment to obeying what might be called the "Bretton Woods rules of the game." 3 This limited infl ationary inertia and prevented infl ation from taking off in response to shocks.

It is now commonplace to ascribe the advent of the Great Infl ation to the 1971-73 collapse of Bretton Woods (Reis, 2021) . In fact, however, Bretton Woods had already lost its bite, and infl ation had already begun to accelerate, in the second half of the 1960s, prior to the 1971-73 Bretton Woods crisis. 4 In this earlier period, the U.S. adopted policies, such as an Interest Equalization Tax on American foreign fi nancial investments, loosening the link between infl ation and gold losses. 5 The Treasury Department asserted its responsibility for managing the foreign exchange market, allowing the Fed to dismiss gold losses and dollar weakness as someone else's problem. There was a decline after 1965 in the frequency of references in the minutes of the Federal Open Market Committee (FOMC) to exchange rate and balance of payments concerns (again see Bordo and Eichengreen, 2013) . 6 As a result, U.S.

downward pressure on the U.S. labor supply, in contrast to Europe's more extensive policies designed to maintain those employment connections and to support continued laborforce participation (Pisani-Ferry, 2022) . For both reasons, infl ation prior to the eruption of war in Ukraine was more subdued in the euro area than the United States. Working in the other direction is that Europe is likely to see more infl ation from rising energy prices, given that it is less self-suffi cient in oil and gas. Infl ation rose to 5.8% in February, on the back of rising food and fuel prices, lower than in the U.S. but still almost three times the ECB's infl ation target. The central bank may be inclined to "look through" rising energy prices if their tendency to rise is only transitory. But it will not be able to look through recession risk if natural gas supplies from Russia are significantly curtailed, whether at the behest of President Putin or the West. By comparison, U.S. reliance on Russian oil and gas, and therefore the risk of a signifi cant slowdown, are less.

Thus, while the risks in the U.S. are clearly tilted toward infl ation, those in the euro area are more evenly balanced. Fortunately, the ECB does not share the Fed's fi xation on the reaction of fi nancial markets, perhaps because Europe has a more heavily bank-based and less market-based fi nancial system. The ECB provides forward guidance, but by the standards of the Fed it is relatively vague. Some observers criticize President Lagarde and the ECB for unclear communication. But the positive interpretation is that the ECB has not gone as far as the Fed in locking itself into a policy position for 2022. This is good. If conditions call for it to accelerate the normalization of policy rates, the ECB will be in a better position to act. Equally, if events in Russia and Ukraine instead lead to an economic slowdown in Western Europe, it will be in a position to pivot. In these highly uncertain times, fl exibility has value.

ings. It has so indicated through speeches by governors and Reserve Bank presidents and through FOMC statements and minutes. By relying so heavily on forward guidance, and by attaching such importance to the state of fi nancial markets, it has eff ectively locked itself into that trajectory. Its fear is that moving faster, in response to more alarming infl ation numbers, would constitute an unpleasant surprise for the markets. It might lead to a sharp correction in asset prices. A sharp shift in interest rates, by wrong-footing investment funds with leveraged positions in fi xed-interest securities, might jeopardize fi nancial stability. This is not the same as 1970s-style denial of the power of monetary policy. But it is evidence of a reluctance to use that power. Unfortunately, this nuance does not make the current policy stance less of a problem.

The issue is that seven 25 basis increases would leave the Federal funds target range at 1.75%-2% at the end of the year, and the real (infl ation-adjusted) interest rate deep in negative territory. Federal Reserve policy would remain highly accommodating -in an economy with unemployment below 4% and infl ation running well above target. For subduing infl ation, the Fed would be relying entirely on declining spending, as the fi scal stimulus of 2021 recedes in the rearview mirror, and on increased supply, as global supply chains recover from COVID-19 era disruptions.

But, for better or worse, consumer spending shows little sign of declining. Although the federal government's stimulus checks may be an increasingly distant memory, households' excess savings, acquired in the pandemic period, still remain to be spent down. Now, moreover, there is the specter of new supply disruptions, as Chinese cities and factories lock down in response to the Omicron variant, containerships are caught in the Black Sea, and fl ows of energy, nickel and grain from Russia and Ukraine grow increasingly uncertain.

This means that the Fed should start laying the groundwork now for a series 50 basis point increases in rates in 2023. Recently, Chair Powell has taken a fi rst step in this direction, but this remains only a fi rst step. By following up with additional statements, the Fed can prepare the markets for the eventuality and avoid the fi nancial volatility of which it is so fearful. It may then be able to move real interest rates back into positive territory by late 2023, when monetary policy will have become less accommodating. Even so, infl ation is likely to remain notably above target for another year and a half, if not more.

A fi nal important question is how diff erent Europe is from the United States. The U.S. applied more fi scal stimulus, in general and specifi cally in 2021, creating more intense infl ationary pressure. In addition, the "great resignation," as workers were detached from their employers during the pandemic, put more

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The Great Infl ation: The Rebirth of Modern Central Banking

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The 'Great Infl ation': Lessons for Monetary Policy

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European Infl ation is Not American Infl ation

Losing the Infl ation Anchor