Two tribes of economists have gone to war over inflation – in the blue corner is ‘Team Transitory’ which expects recent price spikes to fade while in the red corner ‘Team Permanent’ says they won’t and warns we are in for destabilising bout of rising prices.
he battle of the spreadsheets is largely being fought in the US where the consumer price index (CPI) increased by 5.4pc in July from a year earlier. The index is running at a 20-year high and at a pace that is far faster than the Federal Reserve would usually tolerate.
The bruising battle of words and tweets over inflation is a symptom of a wider fight over how best to guide post-pandemic recoveries and the size of the role government spending has in boosting economies and creating jobs after three decades in which demand management was largely left to the world’s central banks.
Team Transitory generally backs the trillions of dollars of spending being proposed by US President Joe Biden and a greater role for the state, while the permanent camp frets that too much money is being pumped in an overheating economy, that debts are spiralling out of control and as inflation rises, rock-bottom interest rates will soar.
We have heard similar warnings from the Irish Government and other eurozone states about debt sustainability and risk of rising inflation and interest rates.
Sadly though, as the default setting in Europe is for ‘frugality’ we won’t even get to ask the questions that have triggered the intense debate seen in the US. More’s the pity, as Covid has presented a once-in-lifetime chance to query the kind of austerity policies that have kept the eurozone so perilously close to recession.
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So who’s winning in the great debate?
Given the elevated annual US headline inflation numbers in July – after a similar reading in June – you would have thought perhaps Team Permanent had scored a knockout blow. After all, cumulative US CPI is up 4.1pc year-to-date – so even if there are no further price rises in the US this year, that will be the annual number – well above the Fed’s 2pc target.
But no. In fact it was Team Transitory claiming the win as July’s core CPI inflation, which strips out volatile items like fuel, came in at 0.3pc a month, below consensus for a 0.4pc rise.
Broad-based price changes signal a problem with the economy… changes in the price of a 2001 Honda Civic do not
The prices of used cars and trucks which have driven much of the rise in inflation were flat, and rent costs went into reverse.
The argument goes that much of the inflation boost has come from one-off items like cars which are a direct result of shortages caused by the end of lockdowns and won’t be repeated.
“The problem with predicting US inflation is that a very small number of items have very big price changes,” noted Paul Donovan, chief economist at UBS Global Wealth Management after the CPI report.
“Broad-based price changes signal a problem with the economy that requires Federal Reserve action; changes in the price of a 2001 Honda Civic do not,” he wrote.
Team Permanent responded with a collective ‘pshaw’ and has accused those on the temporary side of the debate of cherrypicking the data to suit their purposes while ignoring the obvious – inflation is running at 5.4pc and the economy is creating lots of jobs.
Chief among the permanent camp is former treasury secretary Larry Summers, who is widely disliked by those on the ‘progressive’ side of US politics who want to run the economy as hot as possible so as to reduce economic scarring from the pandemic.
“The Fed should be moving with all deliberate speed to tapering. It should be signalling its concern about overheating,” he said recently and warned that failure to control inflation would provoke “very serious political and economic consequences”.
While inflation in the eurozone – and in Ireland – is indeed grinding higher and has breached the European Central Bank’s aim of 2pc, it is not running at the same red-hot pace as the US.
Consumer prices rose by 2.2pc in July from a year earlier both in the bloc and Ireland, up from 1.9pc in June. As a reminder, for all of 2020 in Ireland, inflation was a negative 0.3pc and as recently as February this year it was still in negative territory, reflecting the huge impact the pandemic had on the economy.
If you look at both the Irish and wider eurozone numbers, the rise in prices is largely driven by bottleneck products and services such as energy, fuel, travel and accommodation.
By their nature, those shocks will fade unless there is a big push from rising wages.
According to the European Central Bank (ECB), inflation is expected to spike at 1.9pc this year, reflecting temporary reopening factors, before returning to 1.5pc and 1.4pc in 2022 and 2023, respectively.
As Christian Odendahl of the Centre for Economic Reform wrote in a recent paper, Europe’s problem over the last ten years has been a too little inflation in an economy that has run below potential as policymakers have been unwilling to create enough demand.
The eurozone’s default setting of timidity when it comes to using fiscal policy to close the bloc’s huge gap between current and potential economic output means we are unlikely to experience the fisticuffs of Team Transient and Team Permanent.
As if to prove the point about the moribund debate in Europe, Bundesbank chief Jens Weidmann recently illustrated his concerns over a possible return of inflation with a story about an extinct tortoise.
“Inflation is not dead,” he averred “and if you're not convinced that those believed dead might still be alive and kicking, just ask a biologist: scientists recently confirmed the discovery of a giant tortoise on the Galapagos Islands, even though the species had been considered extinct for over 100 years.”
Yesterday’s eurozone inflation data, however, showed no pressure.
To get inflation moving again, you would need to keep the economy growing above potential for a considerable period, something that governments – including Ireland – have chosen not to do.
After a decade of bad ECB misses on inflation, perhaps Mr Weidmann’s real message is we have to wait another 90 years to find out whether this creature is in fact alive.