Central bankers have had a change of heart.
Until this month, they had argued that inflation was transitory, the expression of unique historical circumstances, and therefore need not drive their decision making. In recent weeks, however, major central banks have reassessed inflation risks and signaled that they are now more worried about its persistence.
This shift makes sense and caution is warranted. But economic policymakers, both central bankers and government decision makers, must remain flexible, attuned to the facts and ready to adjust expectations and responses to rapidly changing conditions.
Prices began to rise throughout the world as the COVID-19 pandemic eased and consumers started celebrating by shopping and spending. The speed of the recovery created bottlenecks, pushing up prices throughout supply chains. The availability of support funds prompted a reevaluation of priorities among workers, creating some shortages in the labor force as well. The mere expectation that prices would increase contributed to inflationary pressures as businesses ratcheted up their prices, to maintain margins or, in some cases, increase profits.
These pressures have influenced the thinking of central bankers. While they once insisted that inflation was “transitory” and the result of a return to normalcy after an intense economic contraction, they are modifying their views. U.S. Federal Reserve Chairman Jerome Powell expressed the new zeitgeist when he warned that “there’s a real risk now … that inflation may be more persistent.”
Central bankers balance two priorities: prices and employment. They have traditionally prioritized the first, raising interest rates, their primary tool for economic regulation, when growth was too fast and needed to control inflation. Unfortunately, a slowing economy generally reduces employment, which means that those two priorities compete with each other.
That tension is evident today. Unemployment rates have been falling, but they remain high relative to pre-COVID-19 levels. In June, the International Labor Organization estimated that the pandemic caused a shortfall of 144 million available jobs in 2020, and while a recovery has been under way, those lost jobs will not be replaced until 2023. In Japan, where labor markets are tight, more than 100,00 people lost jobs as a result of COVID-19. In the United States, it is estimated that 4 million jobs are still missing compared to before COVID-19.
Yet consumer inflation is on the rise, hitting 6.8% in the U.S. in November, its highest level in nearly four decades, and 4.9% in the European economies that use the euro. As a result, central banks are signaling a new concern about inflation and a readiness to combat it. The U.S. Federal Reserve and the European Central Bank have cut or said they will cut support they provide to their economies by purchasing assets, such as bonds. The U.K. and Norway have raised interest rates and the Fed has signaled that it expects to raise interest rates three times next year. Nine emerging economy central banks have either raised their own rates or said they will soon.
Even in Japan, where deflationary pressures have long dominated the economic outlook, there are signs of tightening. In December, the Cabinet raised its overall economic assessment for the first time in 17 months amid hopes of a recovery as the COVID-19 pandemic eases. While the economy shrank a little faster than first reported in the third quarter, a rebound is expected for the final quarter of 2021 as the state of emergency ended.
Consumer inflation continues to be practically nonexistent, but wholesale inflation jumped to 9% in November, the highest year-on-year increase in 41 years, a result of rising commodity prices.
This has pushed the Bank of Japan to trim emergency support measures that it provided in the wake of the pandemic. That change of course has its limits. BOJ Gov. Haruhiko Kuroda has flatly stated that he sees “no possibility of consumer inflation reaching or exceeding 2%, or levels in the U.S. or Europe” and therefore the bank “won’t normalize monetary policy like the U.S. or Europe.”
Uncertainty persists, however. The biggest question mark now is the omicron variant and the threat it poses to that nascent recovery. The evidence indicates that it will not exact a heavy toll on vaccinated populations, meaning that it should not have too profound an impact. But its appearance and the quick and heavy-handed reaction to its emergence are compelling reminders that the situation remains fluid and policy makers must be able to respond quickly to developments. The Japanese government noted that it would “closely monitor” the economic risk posed by coronavirus variants such as Omicron.
Ironically, the most important decision about interest rates may have been made earlier this week in Beijing, where the government for the first time in nearly two years cut its lending benchmark loan prime rate to help shore up a slowing economy. Chinese authorities lowered the one-year LPR by 5 basis points to 3.80% from 3.85%, while the five-year LPR remained at 4.65%. The Chinese government is worried about the impact of COVID-19, an increasingly fragile real estate sector and mountains of corporate debt. Its zero-tolerance policy has meant that localities are subject to sudden lockdowns.
The result has been a falling share of global wealth. Before the pandemic, China accounted for about 35% of global gross domestic product; it is now thought to be 25%. Economists believe that China is likely to grow more slowly than other emerging markets in coming years. That is an adjustment that central bankers can make. If, however, there is a crash or a crisis, then all bets are off. In that situation, inflation will be a minor concern.