We are not referring to China. The reference is to inflation knocking on the doors of the US. It is indeed disturbing as the dragon knocks three decades after Paul Volcker had driven it into the woods. During the interregnum, the Federal Reserve and other central banks secured their autonomy or independence and also polished their tools to better control the demon. Or so they thought. Sadly, the dragon is back from the wild and there are reports of disturbing price trends.
Consumer prices in the US have jumped in October at the fastest rate in three decades. The CPI published by the Bureau of Labor Statistics (BLS) on November 10 rose 6.2% in October from the earlier year—the fastest annual pace since 1990 and a sharp increase from the September level of 5.4%. A sure indicator to flash red lights in the Fed, which is mandated to maintain price stability and inflation at 2%.
What is more gnawing is that the price rise is across all sectors. The energy sector has queered the pitch with the energy index rising by 4.8% from September and the gasoline index by 6.1%. It is an increase that will hurt most American families. More than the actual price increase, it is the fear of the future rise that has gripped their psyche. As Bloomberg reported, “Key drivers like hot housing markets and a global energy crunch show few signs of fading away soon—leading economists to predict even bigger jumps in the coming months.” It added the economy was at a “tipping point” with surging prices eating into the family budgets, wiping out the wage increases the workers got after battles and squeezing the profit margins of small traders.
Consumer prices in the US have jumped in October at the fastest rate in three decades. What is more gnawing is that the price rise is across all sectors. ... If inflation persists in the US, there is risk of dollar appreciation with adverse consequences for emerging markets like India
American President Joe Biden is acutely conscious of the political fallout of rising inflation. He feels perhaps that energy costs are at the root of inflation and has accorded “top priority” to reducing that. He has directed the National Economic Council to pursue measures in this regard. Most importantly, his decision to give another term to Jerome Powell, a Trump appointee, is a sagacious move despite resentment among some Democrats. At a critical time when the Fed has to control inflation, he wants to ensure continuity. It will ensure easy bipartisan approval by the Senate.
The critical issue is whether the current inflationary rise is “temporary” or “persistent”. There have been long debates on this and opinion is strongly divided. In his address delivered at the Economic Symposium at Jackson Hole on August 27, Powell took the view that inflationary pressures are “temporary”’ (‘Monetary Policy in the Time of Covid’). He did refer to the then prevailing rate of 4.2%, which was well above the 2% longer-run objective and was a cause for concern. However, he went on to soft-pedal it with the Fed rigamarole and added, “….that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary”.
It is rather difficult to reconcile Powell’s claim that inflation is transitory with its persistence over months. In a press conference following the meeting of FOMC, Powell said that “transitory” was a tricky thing to define.
On the other side, many economists refer to the rise in demand in the post-Covid months and the supply-demand mismatches. While the demand side may be explained in conventional terms, such as pent-up demand, rush for products after opening, etc., the supply-side issues are more complex. They are as much political as Covid-related.
Essentially, we refer to the disruption of supply chains that evolved during recent decades. These supply chains, mostly China-based, facilitated the smooth flow of products and components seamlessly. In a seminal paper, three economists of the B.I.S. (Bank for International Settlements) explained how global value chains (GVCs) play a valuable role in cross-border trade in intermediate goods and services, an important channel through which global economic slack influences domestic inflation (‘The globalisation of inflation: the growing importance of global value chains’). It was observed that during the years of Asian rise, especially in China, the low-cost Asian trade acted as a buffer against inflation. Former Fed chair Alan Greenspan blamed China for exporting deflation to the US even as he took all the credit for maintaining price stability. When President Donald Trump started his trade-technology war against China, he tried to deconstruct the GVCs. He did not wholly succeed in his efforts. But he had done enough damage.
The US paid the price for those wars through an accelerated rate of inflation. There are commodity shortages in big department stores like Macy’s, Target, etc. Components that go into manufacturing are scarce or high-priced. The flexibility and the speed with which US companies used to adjust to monetary policies may be difficult to achieve. These have to be added to the adverse circumstances or dislocation caused by Covid. The long and short of this is that inflation will persist for a longer time.
Current inflation in the US is more structural and cannot be controlled by adjusting the interest rate. It needs a development policy to promote complementary sectors to bring about a greater balance. That perhaps was why 17 Nobel Laureates applauded Biden’s infrastructure programme.
Getting back, the Fed has a daunting task ahead. The title of the summary of an IMF study put it succinctly, “Inflation scares in an uncharted recovery.” As it added, when expectations are unanchored, inflation can quickly take off and be costly to rein back in. Currently, bond rates do indicate de-anchoring. Under such circumstances, the Fed is rudderless and cannot go by past data or relationships as former Fed chairs Greenspan or even Ben Bernanke did.
If inflation persists in the US, there is risk of dollar appreciation with adverse consequences for emerging markets like India. Studies by the Bank for International Settlements have shown that a stronger dollar is followed by weaker growth in emerging market economies and a higher risk of deeper economic downturns. It will dampen investment growth and exports. It can lead to competitive depreciation and destabilise the financial situation. For countries like India with high crude import, it will create balance of payments deficits. It is a scary scenario.
Powell is said to be the only non-economist to head the Fed. Though he stood up to the bullying by President Trump and maintained independence, many analysts doubt whether he can steer the central bank in choppy waters.
Kandaswami Subramanian
Served in the Ministry of Finance, GOI, and retired as Joint Secretary
(subrabhama@gmail.com)