Harvard Economics Essay

Why Central Banks Must Cede Autonomy to Curb Inflation This Time

Nayantara Maitra Chakravarty

For nearly four decades, economies in the developed world had got used to low inflation, till COVID infected them in 2020, shutting down factories, offices, and shops. Policy-makers used increased government spending as a cure, handing out subsidies as emergency medicine, and central banks flooded their domestic economies with ‘easy’ money. This reversed the monetarist mantra that dominated economic policies in the West since the 1980s, which gave central banks the autonomy to calibrate interest rates to keep inflation down, and required governments to be fiscally austere.

The logic that governed such policies was that inflation is always caused by excess money- supply, especially when productive assets are almost fully employed. If raising capital becomes easy, individual capitalists will be willing to pay more for equipment and labour, pushing up input-costs, while workers would want higher money-wages to give up leisure (the marginal disutility of labour). With higher money-wages, workers will compete to buy the commodities available to them, since supply will always ‘lag’ behind demand. This will allow capitalists, who are paying more for their inputs, to ‘mark-up’ their output. As prices go up, workers will build in higher ‘inflation-expectations’ for the future, demanding even higher money-wages. This will set-off a money-wage spiral which would blow up into accelerated inflation.

Reversing this process would, logically, bring inflation down. If central banks raise interest rates and use other instruments to reduce money-supply, then capitalists will find it harder to raise money, and be less willing to pay higher money-wages to workers. This would slow the economy down, reduce ‘aggregate’ demand and bring down prices. As inflation slows, workers too would readjust their inflation-expectations and accept lower raises to their money-wages. Central banks have been trying to do this, since the ‘Volcker shock’ of 1981, by fine-tuning interest rates to bring inflation down to 2 percent. On the other side, governments since the Reagan-Thatcher days of the 1980s, have tried to cut down on welfare spending and subsidies to ensure demand does not outstrip money-supply.

This time, central banks were somewhat behind the curve; they reacted slowly to inflation, which had started climbing from the middle of 2021. Then, in 2022, they raised rates with a vengeance – the US Fed has raised its signal rate by four percentage points, the Bank of England has raised rates by 3.5 percent since December 2021 (3.25 percent in 2022 alone), and the European Central Bank has raised its rates by 2 percent in 2022. Central bankers have warned that more rate-hikes are in the offing if inflation does not get tamed.

There are two key questions here:

1. Is curbing inflation good for the global economy?
2. Can the current inflation-trend be controlled through central bank action, especially in

the USA and Europe?

Till the late ‘Great Inflation’ period of 1965-1982, and even more so the ‘stagflation’ era of the 1970s, inflation was considered to be a necessary fallout of sustained economic growth and high employment. This was famously captured in the Phillips Curve which postulated that the higher the amount of ‘slack’ in the labour-market (unemployment), the lower is the money-wage required to get people to work. Conversely, the lower the level of unemployment (tight labour- market), the higher the money-wages. Since money-wages constituted a key part of costs, the Phillips Curve could be restated to say that full-employment will always cause inflation. This was of a piece with the Keynesian policies that post-depression (and post-war) governments followed, where they ran fiscal deficits to stimulate aggregate demand, to ensure near-full employment of resources. Although Keynes himself shared an aversion to inflation with the monetaristsi who succeeded his school, the idea that inflation had to be tolerated – and might even be necessary – to give jobs to all, has come to be identified as a key element of the Keynesian doctrine.

The 1970s, when high inflation was accompanied by a rise in unemployment, contrary to what the Phillips Curve predicted, ended the dominance of Keynesian policy-making. It opened the door for monetarist policies, which had predicted that deficit-financing generates demand bubbles, which ultimately burst and cause even higher unemployment. Instead, the monetarists argued that if markets were allowed to function unfettered by government intervention, ‘free- market’ capitalism would be able to provide employment to everyone at some market-clearing wage-rate. Only those who voluntarily wanted to stay out of the labour-force would remain unemployed.

The sharp drop in inflation since the mid-1980s was seen as a sign of the sagacity of monetarism. Little credit has been given to the fact that money-wages were kept in check by outsourcing labour and manufacturing to the developing world, where labour was cheap. Workers had to accept a lower rise in money-wages, at times even less than the already low inflation-rate, because there were fewer high-wage jobs available. Throughout much of the ‘roaring’ 90s, real wage-growth in the USA was negative, ii in a decade when the economy was booming, and at the end of which, the government could reverse decades of budgetary deficits to register a surplus. iii

Low inflation of the 1990s allowed central banks to drop interest rates sharply. From the near-20 percent rate under Paul Volcker in 1981, the US Fed dropped rates to below 3 percent by the end of 1992. This reversed the long-term trend of a decline in the profit-rate in the US economy, because two key costs – labour and finance – had dropped significantly.iv The low-interest rate regime (that intensified in the early 2000s), aggressive financial deregulation in the Clinton- years, and IMF-World Bank mandated relaxation of capital controls by emerging markets, also unleashed a new phase of capitalism – the dominance of finance. Finance could now easily traverse the globe seeking higher returns.

Inflation-targeting, therefore, resulted in a complete reversal of the distribution of income between capital and labour in the USA and Europe. This is evident from the income-share and real-income estimates calculated by the World Inequality Lab, led by Thomas Piketty and Lucas Chancel. It is clear that the so-called ‘Keynesian’ period, that began after the 1929-crash and lasted till the end of the 1970s, was better for the poorest 50 percent of Americans than the monetarist period that has followed. On the flipside, the low-inflation, low-interest rate, period has been much better for the richest one percent.

(See Charts 1 and 2 below) v.

Most economists agree, if central banks continue with their aggressive tightening, USA and Europe could go into a recession in 2023, and unemployment rates could climb sharply, causing a “Wile E. Coyote moment... in which demand collapses.” vi Questions are being raised about how effective interest rate hikes can be in curbing inflation, especially in Europe where it is being driven by higher energy and food prices. Both of these are price-inelastic and are unlikely to see any drop in demand, just because interest rates have been hiked. If energy and food prices do not moderate, then the inflation-expectations of average consumers will continue be high, and workers will continue to look for higher money-wages.

There is also the problem of ‘imported disinflation’; when central banks in the developed world raise rates, those in the emerging economies will have to follow suit, to stop a flight of finance from their markets. Some capital exodus will still take place causing emerging market currencies to depreciate. Both of these will make imports cheaper for developed countries, and bring domestic prices down, independently of central bank actions. If Western central banks do not consider this in their inflation-targeting models, their economies might contract much more than intended. The only way to avoid this is for central banks to consult with each other and closely coordinate their policy responses, to both tailor them for domestic needs and adjust for the price- impact of external trade. vii

Some heterodox economists have argued that, contrary to monetarist beliefs, increased government spending could help curb inflation. If governments increase subsidies, workers will need a smaller increase in money-wages to cope with inflation, thus both reducing input costs and moderating inflation-expectations. viii In fact, in Europe where food and energy prices are driving inflation, central banks can do nothing; governments can. Increased fiscal spending can also be financed through higher taxes on supernormal corporate profits, which have been both the cause and effect of the high inflation in the post-COVID recovery period. ix

This means central bank ‘autonomy’ has to be rethought; monetary policy has to not only work in tandem with fiscal policy, it has to also subordinate itself to the imperatives of government spending. Central banks will also have to cede their autonomy vis-à-vis other central banks to act in a coordinated fashion. This, once again, will require geopolitical balancing acts, which only governments are equipped to handle. This is the only way to ensure that inflation can be curbed without pushing the global economy into a harsh recession.

i Humphrey, Thomas M. ‘Keynes on Inflation’ Federal Reserve Bank of Richmond. https://www.richmondfed.org/- /media/RichmondFedOrg/publications/research/economic_review/1981/pdf/er670101.pdf. Accessed on 12 December 2022.

ii Desilver, Drew, ‘For most US workers, real wages have barely budged in decades’ Pew Research Centre, August 7, 2018. https://www.pewresearch.org/fact-tank/2018/08/07/for-most-us-workers-real-wages-have-barely-budged-for-decades/ Accessed on 14 December 2022

iii Schick, Allen, ‘A Surplus, If We Can Keep It: How the Federal Budget Surplus Happened’ Brookings, December 1, 2000. https://www.brookings.edu/articles/a-surplus-if-we-can-keep-it-how-the-federal-budget-surplus-happened/ Accessed on 14 December 2022

iv Shaikh, Anwar, ‘Crisis, Austerity and the Role of Economic Theory in Policy’ Social Research, Fall 2013, Vol.80, No.3. Pp.656-7

v Authors calculations based on data provided at the World Inequality Database. https://wid.world/country/usa/. Accessed on 22 December 2022.

vi Summers, Lawrence H., ‘What the Fed Should Do Next on Inflation’ The Washington Post, December 19, 2022. https://www.washingtonpost.com/opinions/2022/12/19/larry-summers-fed-inflation-next-steps/

vii Obstfeld, Maurice, ‘Uncoordinated monetary policies risk historic global slowdown’ Petersen Institute for International Economics, September 12, 2022. https://www.piie.com/blogs/realtime-economic-issues-watch/uncoordinated-monetary-policies- risk-historic-global-slowdown. Accessed on 22 December 2022.

viii Patnaik, Prabhat, ‘On Controlling Inflation’ Economic & Political Weekly, Vol.49, No.45 (November 8, 2014), Pp. 45-46.

ix Bivens, Josh, ‘Corporate profits have contributed disproportionately to inflation. How should policymakers respond? Economic Policy Institute, April 21 2022. https://www.epi.org/blog/corporate-profits-have-contributed-disproportionately-to-inflation-how- should-policymakers-respond/ Accessed on 22 December 2022