As the world emerges from COVID, economies are revving back to life - but so is something that many parts of the world have not seen much of for decades - inflation.
What is inflation, and should we worry? An interview with Paul Donovan
Robin Pomeroy: Inflation is something everyone has been talking about and you even wrote a book about it called The Truth About Inflation, which is exactly what we want to get to in this interview: What is inflation? What is true, what is false about it? Why is inflation for you, as an economist and as an individual, such an important issue?
Paul Donovan: It's important because I think it's it's very often misunderstood. We have this idea that there is a single inflation number which affects us all. And that just isn't true. The inflation experienced by older people tends to be higher. The inflation experienced by lower income people tends to be higher because of what they buy. Older people buy healthcare, lower income people are buying food, energy and housing in disproportionate amounts. And that gives them a higher inflation rate. So really, if you want to avoid inflation, you need to be young and rich.
Investors also, I think, get very confused about aspects of inflation. So consumer price inflation, which is the number most people look at, actually is not a very good guide to corporate pricing power because companies tend not to sell to consumers - companies sell to other companies. So it's a different measure - producer price inflation - that gives us a better indication of pricing power. Costs are driven by wage inflation. So this idea that there's a single nice statistic that tells us everything we need to know about price changes just isn't true, and we need to really understand the detail of what's going on to properly be able to assess the economic consequences of inflation moving up or inflation moving down.
Do we believe the inflation rate?
Robin Pomeroy: Individuals, we as people, sometimes find it hard to accept the official inflation rate because of biases we may have. Could you explain that a little bit?
Paul Donovan: People never believe the official inflation statistics, and they tend to believe that inflation is higher than it actually is. Why is that? Well, it's two behavioural economic concepts which are actually very well understood. So the first is loss aversion, and this is the fact that we are genetically programmed to remember and react to bad news more than good news. We run away from the sabre tooth tiger three times as fast as we run towards our next meal. So because of loss aversion, which is this sort of ancient behavioural trait, people remember price increases and they forget about the price cuts. And so you end up with this sort of bias that you're ignoring the fact that your flat screen TV fell in price last year, and you're remembering the fact that the price of your Snickers bar has gone up over the course of the last year.
Because of loss aversion, which is this ancient behavioural trait, people remember price increases and they forget about the price cuts.
But then we have this second behavioural trait, which is frequency bias, and this is a really big problem. People remember the price of something they buy frequently - that means food and fuel. The result is you get a very distorted view of what's driving inflation. So, for example, if I come into my office and I see that the price of a Snickers bar in a vending machine here has gone from 50 pence to 60 pence, I know I'm going to get colleagues coming up to me all the time and saying, 'inflation's out of control, we've got 20% inflation'. Now, with the best will in the world, my colleagues can only consume so many chocolate bars in a 24-hour period - it's not a major part of their overall budget. But every single time they go to the vending machine, they're reminded the price has gone up by 20% and that sticks in the mind. And so what we then have is this combination that we are focused on high-frequency purchases, and we tend to remember the price increases not the price declines. And that can give us a very distorted view of what's going on with average prices in the economy.
What's happening with inflation now?
Robin Pomeroy: So what is happening with inflation now globally? Everyone's talking about a resurgence in inflation. It seems that in many parts of the world there's not been inflation that's been above a point that we would consider problematic in many parts of the world, but now perhaps we are at a point where that's the case. Could you tell us - is that true what I'm saying, that there has been this historical period? And what is happening now?
Is this really inflation? That's that's where economists start to disagree.
Paul Donovan: In developed economies, by and large, we have had a 20-25 year period of pretty low inflation. Now there's been the odd spike, but generally speaking, prices have come in sort of around a 1.5-3-3.5% range of increase every year on an average index. And that, of course, is perfectly fine.
What we're now seeing is inflation rates come in quite a way above that. So in the United States, the latest inflation number for headline CPI - consumer price inflation - is 7% year over year, which is a very high number. Now is this really inflation? Well, that's that's where economists start to disagree a little bit. Because inflation is a general increase in prices, lots of prices rising by a large amount, all at the same time. And that's important because if lots and lots of prices are rising, that's telling you that there's an imbalance in the overall economy and that's something that policymakers need to address. But if you've got one or two prices rising a lot and other prices behaving more or less normally, then that's telling you that there's a problem in one or two markets, but not in the economy at large. We have got slightly stronger inflation for most of the economy and one or two price increases that are really quite extraordinary. And that's a pattern that we're seeing pretty much globally. Energy is behind a lot of the headline numbers. The used car market, the new car market, has also had some distortions because there have been problems with supply there over the last year. This is what's really pushing up the the headline inflation rate.
Inflation - the policy makers
Robin Pomeroy: At a recent conversation at the Davos Agenda, we had senior economists and central bankers talking about inflation. The head of the IMF, the head of the Bank of Japan, the head of the European Central Bank. I'd like to play you a clip from Christine Lagarde, the governor of the European Central Bank, with her view on where inflation is at right now.
Christine Lagarde (speaking at the Davos Agenda 2022): We have to ask ourselves, where is it [inflation] coming from? Is it likely to last? And we are trying to figure out how long it will last, because that is going to be critical in really composing the policy response that will be needed. And what do we see under the numbers? Well, we see 50% energy prices. It is not just the recovery, it is also geopolitical factors that are critically important at the moment, unfortunately. It is also some idiosyncratic factors. It is some weather-related factors. And the rest, essentially, taking out a few base effects that will eventually clear out in the next month, actually, we see a lot of this super-strong recovery that has outpaced supply, which was constrained. And as a result of that, you all, we all, talk about the bottlenecks, the congestion of ports, the lack of truck drivers and what have you. So then you ask yourself: these two big factors, are they going to be with us for the long term? Are they going to affect this inflation number and make it sustainable? And will that dictate our monetary policy response?
We are not seeing this sustainable movement that would lead to inflation spiralling out of control. On the contrary, we assume — and again, lesson of humility here, there is a lot of uncertainty about it — but we assume for the moment that energy prices will stabilise in the course of '22, that those bottlenecks and those congested ports and drivers missing in action, and all the rest of it, will also stabilise in the course of '22, and that gradually those inflation numbers will decline.
Robin Pomeroy: Christine Lagarde, governor of the European Central Bank, seemingly cautiously optimistic that inflation will start to come back under control because the things she mentioned are transitory problems there. Do you agree with her forecast?
Paul Donovan: Broadly, I would agree with President Lagarde that inflation is going to come down because the increase in the oil price is slowing, and that means the contribution of the oil price to inflation is slowing. And other factors, I think, are also going to be coming down. Demand, which has been quite extraordinary, is going to normalise as we go through this year.
We're hearing a lot from policymakers about supply chain problems and supply chain bottlenecks. This is politics - it's not economics. Because when we look at what's happened with global supply, global supply simply surged last year. Global manufacturing output: all time record high. Global volume of trade: up 11% on the World Trade Organisation's numbers. The volume of shipping through the Suez Canal: all-time record high, even with ships going sideways, they still get an all-time record high volume of shipping! So we're seeing supply chains work wonderfully throughout 2021. This idea that supply chains are crumbling ruins around the world is complete nonsense.
You've got to go back to the end of wartime rationing to see so strong a surge in demand for durable goods.
But what we had last year was a simply extraordinary level of demand. In the United States, demand for durable goods surged in the strongest increase we have seen since 1946. You've got to go back to the end of wartime rationing to see so strong a surge in demand for durable goods. And why was that? Well, that was because, during the pandemic, people saved money and once they were released from the restrictions around COVID and were able to go out and spend the money, they went out and spent the money. So you've had this extraordinary, extraordinary surge in demand, which has overwhelmed a valiant effort by supply to meet that demand. So here we have a bit of an imbalance in the economy. Demand is a lot stronger than supply, and that has pushed up some prices of goods. But of course, that surge in demand cannot last, and we're already starting to see it fade in the US and possibly also in the UK. Because once the savings are spent, you have to go back to normal levels of demand. And that seems to be where we're moving to. And as we normalise demand, we're going to normalise inflation rates with a little bit of a lag because prices take a little while to adjust, but normalising inflation seems to me very, very likely this year.
Robin Pomeroy: So we should all take a deep breath and kind of ride this wave. I guess the question is with inflation is: will it spiral? Let me play this little clip from someone else on that panel at the Davos Agenda week. This is Brazilian Economy Minister Paulo Guedes.
Paulo Guedes (speaking at the Davos Agenda 2022): I don't think inflation will be transitory at all. I think these supply adverse shocks will fade away gradually, but there's no arbitrage anymore to be exploited by the Western side. So I think the central banks are sleeping at the driver wheel. They should be aware. And I think inflation will be a problem, a real problem, very soon for the Western world.
Inflation - what causes a spiral?
Robin Pomeroy: So that was Paulo Guedes, the economy minister of Brazil, taking the other opinion, saying that things will spiral out of control. What are the risk factors that do push inflation to spiral upwards? What are the policy levers available and whether they might or might not be useful this time around?
Labour costs in a developed economy are about 70% of inflation.
Paul Donovan: So the simple answer is labour costs. Now, labour costs in a developed economy are about 70% of inflation. We all focus on things like commodity prices. Commodities really aren't that important to inflation - about 15% is down to commodities. Labour costs are the big one. And it's important to recognise here that we're not talking about wages. So wages is how much you take home. But actually what a company is interested in when it's setting prices is, 'how much do I have to spend on labour entirely to produce a unit of output?' The wage rate going up is not all we've got to consider. We've also got to consider how hard are people working, because if people are working harder, then they should be paid more money, something I repeatedly remind my bosses of. If you've got people who are working harder, they're producing more output - paying them more money isn't necessarily inflationary. So the US restaurant sector is a really good example of this. If we look at the data for December, restaurant sales in the United States were over 19% higher than they were in January of 2020. But you've achieved that increase in restaurant sales with 2.3% fewer staff. So in that situation, of course, what's happening is staff are working harder or in some restaurants staff have been replaced by computers. The only thing the restaurant employee does is actually prepare the food for you. So this automation means that you can use fewer people to achieve more output, and so therefore you can afford to pay those people a little bit more. So the way that economists look at this is through something called unit labour costs. Now the problem with unit labour costs is this is data that's revised very, very often, and it's not a very stable statistic, to be perfectly honest. But that's really what we're looking at. If we start to see wages increasing more rapidly than output is increasing, that would be something that would start to be problematic because then those wage costs would be passed on in higher prices and then workers may respond with increased wage demands.
I think it's very unlikely to happen. It happened in the 1970s in a very, very different world. The US president, President Nixon, was setting wages and prices personally, it was a state control. The price of hamburger in the United States was personally set by President Nixon in the Oval Office. Quite remarkable. And that whole collapse of that pricing structure led to an inflation bout. The unionised nature of wage bargaining also led to increased inflation pressure. We're nowhere near any of that now.
Inflation, wages and productivity
Robin Pomeroy: You're talking about this word 'productivity' there aren't you? That's the term economists use. So 'it's OK to increase wages if productivity increases'. I just wonder, I mean, in a hamburger restaurant that might apply, but what about lots of areas where the output is quite difficult to measure? What about the millions of people who work in schools and in hospitals? How do you measure the productivity of a teacher or of a nurse? You know, a nurse who's worked her fingers to the bone, or his, through the pandemic, who deserves a pay rise, who's got to deal with these inflationary pressures. There will be pressure, won't there, to increase wages for millions of people around the world, very often low paid people who have tough jobs. But it's very hard to measure, I would have thought, productivity increases for them, isn't it?
Paul Donovan: It is. There are ways that you can try and do this and you have to come up with, you know: 'What is the value of healthcare?', 'What is the value of education?' It's controversial. The UK, for example, measures the value of education based on the number of students that are taught, whereas France measures the value of education based on how much they pay their teachers. There are more and more sophisticated ways of measuring output, which is helpful and which does allow us to see a little bit more about what's going on in terms of productivity and the value of what people are producing in the economy. But we've got to recognise that the pandemic has accelerated an awful lot of structural change, and data is scrambling to keep up with this. But things like working from home change productivity, change efficiency. The increase of self-employment, we've seen a massive increase in self-employment in many, many developed economies in the aftermath of the pandemic. That's not necessarily being captured in the data, but it's still output and productivity and income. So it's becoming a lot more complicated as we go through this structural upheaval in the economy.
The inflation policy levers
Robin Pomeroy: So let's talk a bit about the policies now. We've quoted central bankers who are in charge of setting interest rates. Could you just take us back to the basics and say what is it that policymakers are looking out for and what is it they can do, at least in theory, to control inflation?
There's a limit to what central bankers can do. There's some prices that they've got to sit there and say: 'You know what? Sit it out for 12 months and this is going to stop being a problem'.
Paul Donovan: We have fiscal policy, we have monetary policy, and inflation is generally put down to the monetary policy makers. That's not always entirely practical. So if we look at some of the current inflation, there's nothing Fed Chair Powell can do to change global oil prices. He is not a used car sales person. There's nothing he can do to change the price of a 2001 Honda Civic. So there's a limit to what central bankers can do. There's some prices that they've really got to sit there and say, 'You know what? Sit it out for 12 months and this is going to stop being a problem'. And that's effectively what central bankers are having to do. But there are other prices that they can influence, and they can influence to some extent wage growth, indirectly, they can influence some other cyclical prices by influencing the cost of credit in the economy. And by raising the cost of credit - raising interest rates - what of course you are doing is limiting the ability of people to demand goods and therefore you bring supply and demand into balance, and that helps reduce inflation pressures. You may also give people an incentive to save money rather than spend money if you've raised the interest rate. But we have to recognise the limitations. We've just got to burn through this demand and then after that see where we are. And so that's what I think is is happening. Central banks know that inflation is going to be coming down this year because the technical factors are going to fade. So what they are looking to do is not to sort of squeeze inflation out of the system - they're not looking to create a recession. What they're looking to do is have interest rates that are a level that allow growth after this demand surge to settle back into a more normal pattern. And that's quite a less aggressive policy than when you're trying to actually push down on inflation. Central banks are saying, 'Look, inflation's coming down, and once it's down, we want to keep it there'. That's a slightly different approach that they're going to be taking.
Robin Pomeroy: Let's just go back to inflation as this kind of bogeyman that some people fear. And you've got countries, haven't you, that have this collective memory of something far worse than that - of hyperinflation? We know that the Germans, even people who aren't old enough to remember it, there's still this kind of societal memory of hyperinflation there. Could you remind us what hyperinflation is and how bad inflation can get and why we should be so scared of it in those circumstances.
In a hyperinflation episode people can lose everything.
Paul Donovan: There isn't really a formal definition of what hyperinflation is. I would say that once you're talking about a 50% inflation rate, you're getting pretty close to a hyperinflation scenario. And it's where prices are changing constantly. That becomes socially disruptive. You're changing social status of people. You're changing the relative value of jobs, of positions in society, of incomes. Normally, a hyperinflation episode involves a huge transfer of wealth from savers to borrowers. Borrowers benefit, savers suffer. And that's what people remember. Again, it's that loss aversion. In a hyperinflation episode people can lose everything - they lose their social status, they lose their income. And that's why hyperinflation episodes tend to be remembered for multi-generations. So Germany had two hyperinflation episodes: 1923 and then immediately after the Second World War. Singapore is another interesting society where there's a very strong fear of inflation coming, not from Singapore's hyperinflation episode, but from the hyperinflation of nationalist China after the war and then a lot of emigres from nationalist China went and settled in Singapore and they took with them the memory of the very, very destructive power of a very, very high inflation rate. So hyperinflation tends to cause considerable concern.
If you've got an economist running a central bank, you will not have hyperinflation.
It's something which happens deliberately, to be perfectly honest. If you've got an economist running a central bank, you will not have hyperinflation because hyperinflation is essentially caused by printing too much money. In 1923, the Reichsbank's President Havenstein in Germany, who wasn't an economist, he was a lawyer, responded to the German economic situation just simply printing more and more money. And this famous occasion where he gave a speech saying, 'Don't worry, we've ordered more printing presses. We're going to be able to print even more money and it will all be fine. And that will get rid of the inflation.' Complete misunderstanding of what was going on, to the extent that by the end of the hyperinflation episode, the central bank was printing money where they only printed one side of the banknote, the other side was blank paper because there wasn't enough time to print both sides of the banknote before the money devalued and lost all sense of value.
We've seen that more recently in places like Zimbabwe, the worst hyperinflation episode ever was in Czechoslovakia after the Second World War. So we've had all of these these episodes. It's caused by a complete failure to observe the laws of economics. As long as you observe the laws of economics, you maintain some semblance of balance between money supply and money demand.
Robin Pomeroy: That's a reassuring note, perhaps on which to end it. Paul Donovan, thanks very much for explaining inflation to us. We're going to keep a close eye on it. Thanks for joining us on Radio Davos.