What would you do if inflation and interest rates remained high, not just for the rest of this year, but for a few years to come?
It’s a question that investors and homeowners might want to start thinking about, given recent readings from Europe and the United States.
The new numbers suggest that global inflation is not fading away as quickly as markets had hoped at the start of the year. Despite good news on supply chains and energy prices, underlying price pressures appear to be subsiding only slowly, if at all.
In the U.S., the Federal Reserve’s preferred measure of core inflation – that is, inflation without energy or food prices – rose in January instead of falling as forecasters had expected.
In Europe, meanwhile, core inflation in the euro zone hit a record high in February.
Both those gauges hint at a worrisome prospect – the possibility that higher inflation might be on the verge of becoming embedded in economies.
There are at least a couple of reasons to think this is plausible. Soaring corporate profits during the pandemic demonstrated that companies have been highly successful in passing on price increases to their customers. Meanwhile, drum-tight labour markets imply that workers are in an excellent position to demand higher wages.
Both trends suggest inflation could stay high for a while, although opinions differ as to how high and for how long. The vast majority of economists still predict that inflation – now running around 6 per cent a year in both Canada and the U.S. – will head significantly lower over the rest of this year.
Doubts are beginning to emerge, however, about how far inflation can fall in the absence of a good-sized recession. Jason Furman, a Harvard economist, tweeted this week that current wage growth in the U.S. is consistent with 4-per-cent inflation. The pattern in Canada is slightly more subdued but broadly similar.
With unemployment levels in both countries at multidecade lows, wages are likely to continue growing at a rapid pace so long as recession is avoided. But if wages are powering ahead, inflation and interest rates will probably remain elevated, too.
“If your business or your home-refinancing plans depend on interest rates going back to 3 per cent soon, things could get a bit difficult,” the economist and blogger Noah Smith warned in a post this week. He sees a decent possibility that 4-per-cent inflation will emerge as the new norm over the next few years.
For central bankers, this would amount to a no-win situation.
Four-per-cent inflation is double what the Bank of Canada and the Federal Reserve prefer. It’s not outrageous, though, by historical standards. During the 1980s, both Canada and the U.S. managed to prosper with inflation around that level.
Central bankers could therefore decide to proceed with a light touch in a 4-per-cent world. They could keep their key interest rates at elevated but not brutal levels – say, around 5 per cent – and hope that inflation gently declines over the coming years.
But that runs some major risks. One is that a new emergency might send inflation soaring from its already elevated level and turn a moderate headwind into a full-fledged inflationary hurricane. This is what happened in the 1970s, when inflation soared to double-digit levels after the 1973 oil crisis, tumbled to around 5 per cent in 1975, then rebounded to even more mountainous highs by the end of the decade.
Another risk is that making peace – even temporarily – with 4-per-cent inflation might sacrifice central bank credibility. The Bank of Canada is publicly committed to keeping inflation between 1 and 3 per cent. The Federal Reserve is similarly wedded to a 2-per-cent target. If central banks can’t steer inflation to those levels in a timely fashion, they are failing a fundamental responsibility.
The problem is that they also have a responsibility to maintain a healthy economy. The key question is just how much pain central banks should be willing to inflict to get inflation quickly back to earth if it were to remain stuck at around 4 per cent.
Engineering a recession and throwing multitudes of people out of work simply to squeeze one or two percentage points out of inflation would be politically explosive. But it might be seen as a necessity.
“There is no post-1950 precedent for a sizable central-bank-induced disinflation that does not entail substantial economic sacrifice or recession,” according to a discussion paper last month from Stephen Cecchetti, a finance professor at Brandeis University, and several prominent co-authors.
For now, the disappointing run of inflation readings around the globe casts doubt on the assumption that interest rates will be falling by the end of the year. Until inflation falls below 4 per cent, central banks are likely to remain obstinate. We still have a long way to go.
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Ian McGugan