Martin Wolf, the Financial Times’ associate editor and chief economics commentator, is worried that the Federal Reserve of the US has allowed inflation to get out of control; bringing back to earth will be painful. (His article was titled The Fed must act now to ward off the threat of stagflation (Financial Times, May 24 2022)
He starts by asking if we are moving into a new era of higher inflation and weak growth, similar to the stagflation of the 1970s? He writes, “The similarities are evident between the present ‘surprise’ upsurge in inflation to levels not seen in four decades and that earlier era, when inflation was also a surprise to almost everybody, except the monetarists. That era was also characterised by war — the Yom Kippur war of 1973 and the invasion of Iran by Iraq in 1980. These wars, too, triggered jumps in oil prices, which squeezed real incomes. The US and other high-income economies experienced almost a decade of high inflation, unstable growth and weak stock markets.”
By 1980 US inflation was over 14%. It was brought under control by Paul Volcker, chair of the Federal Reserve, through very painful rises in interest rates -up to over 20% - leading to recession 1981-2. Unemployment rose to over 10%. The stock market fell into bear territory.
This is taken from the history section of the Federal Reserve website: “[Volcker] believed that the Fed faced a credibility problem when it came to keeping inflation in check. During the previous decade, the Fed had demonstrated that it did not place much emphasis on maintaining low inflation, and public expectation of such continued behavior would make it increasingly difficult for the Fed to bring inflation down. “[F]ailure to carry through now in the fight on inflation will only make any subsequent effort more difficult,” he remarked in 1981.”
The noise around the Fed’s "credibility problem" in 2022, with inflation now over 8% is going to get louder and louder. It will do so until they act harshly to prove they are not soft on the problem.
On 31 May President Biden met Jerome Powell of the Fed to express his support for any toughness he might think necessary to deal with inflation. The President said he would give the Fed “the space they need to do their job, adding, “I’m not going to interfere with their critically important work.”
Martin Wolf points out another similarity with the 1970s. That is, the rise in inflation was, and is, blamed on supply shocks caused by unexpected events. But that was not the only, or even the main, factor either then or now. This main issue is the pumping up of demand from American consumers for goods and services caused by the vast amounts of hand outs from government and very low interest rates.
“Excess demand causes supply shocks to turn into sustained inflation, as people struggle to maintain their real incomes and central banks seek to sustain real demand.”
There comes a point when policymakers realise that if they keep pumping up demand all that will happen is that inflation goes higher and higher. When they, rightly, stop the boosting incomes fall or stagnate. At the same time the momentum in inflationary expectations cause prices to keep on rising at unacceptable level. Then we have for a while “StagFlation” – at the same time as the economy has stagnated, inflation still rages.
“This then leads to stagflation, as people lose their faith in stable and low inflation and central banks lack the courage needed to restore it.”
It’s Martin Wolf’s view that US equity investors have not yet cotton-on to consequences of the stagflation scenario:
“At present, markets do not expect any su.......
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