Confirmation bias being what it is, inflation hawks and doves have each been able to point to evidence in recent days to prove their point.
On the one hand, measured inflation in Canada and the U.S. is running substantially higher than recent experience, official targets or most forecasts would have suggested. Consumer prices in Canada rose by 3.6 per cent over the latest 12-month period; in the United States, by 5.4 per cent; the highest numbers, in either case, in more than a decade.
On the other hand, bond markets, which are supposed to faint at the first whiff of inflation, seem unperturbed. Ten-year bond yields in both countries, which had been rising earlier in the year, have been falling over the past month, and now sit at roughly 1.3 per cent.
Markets appear to have accepted central banks’ assurances that higher inflation is merely transitory, reflecting “base effects” (prices were falling a year ago, magnifying any year-over-year comparison) and other artifacts of the now-departing pandemic: supply-chain constraints, pent-up consumer demand and so on.
Move along folks, no story here? Well, maybe. Markets are accurate barometers of current wisdom, but they are not infallible. The picture is if anything worse than the year-over-year numbers would suggest. Since the start of the year, inflation in Canada has been running at an annualized rate of 6.4 per cent (4.0 per cent, seasonally adjusted).
More to the point, inflation seems likely to linger above its target rate – 2 per cent in the United States, 1 per cent to 3 per cent in Canada – for years to come, as central banks themselves now acknowledge.
They have simply adjusted their definition of “transitory” to match. Inflation may now be running above target, the heads of both the Federal Reserve and the Bank of Canada have lately observed, but it is expected to return within range sometime in the next two to three years.
These are the same central banks, of course, that persistently undershot their inflation targets in the years prior to the pandemic. Might they be as prone to overshoot in the very different environment in which we now find ourselves?
At this point all one can say is: Let’s hope not. Indeed, we must not only hope that inflation, now that it has had a chance to stretch its legs, will return as meekly to its cage as the official line suggests, but more importantly, that the public can be persuaded to believe it will. The situation, notwithstanding official blandishments, is fluid and unpredictable; all depends on which way inflation expectations break.
It is not quite true to say that inflation can be a self-fulfilling phenomenon. Sooner or later inflation is, always and everywhere, a matter within central banks’ control. What is true is that what people believe about the future course of inflation – expectations – can make the job of stamping out actual inflation difficult or easy: relatively costly, or relatively cost-free.
If people expect inflation will remain stuck at 2 per cent, then even if inflation should jump to 4 per cent or 6 per cent in the short term, they will refrain from demanding a correspondingly large increase in longer-term wages or prices. A light tap on the monetary brakes will be enough to restore the economy to a non-inflationary growth path.
But let higher inflation become embedded in expectations, and that benign disinflationary scenario is impossible. Reining in inflation in that case becomes a much more ugly and protracted business, using recession and rising unemployment as the blunt instruments with which to bludgeon wage and price-setters into moderating their demands.
Actually, that’s not even the half of it. For expectations not only involve the future course of prices, but the likely response from central banks: how determined they are to stamp out inflation, once it has broken out. Which in turn will be influenced by the probable cost of doing so: economic, social and political. Or so people might suppose.
If people believe that curbing inflation will be a horrific and lengthy task, achieved only at great cost in human suffering, they may also believe that central bankers will not have the stomach for it. Which, paradoxically, might lead them to behave in ways that make the job even harder. That is, they might disbelieve official statements about the future course of policy, and the likely inflation rate that would result.
Suppose central banks say they intend to reduce inflation from 4 per cent to 2 per cent, but people assume they’re bluffing. They therefore continue to demand increases of 4-per-cent-plus in their own wages and prices. If inflation indeed comes in at 2 per cent, then real wages, after inflation, will have risen by 2 per cent. The result of this unexpected increase in the cost of labour: higher unemployment.
And yet they may bet on 4 per cent all the same: not just because they think central banks would prefer to avoid such a result, but because of how they think other wage- and price-setters might behave. If, that is, the others demand 4 per cent – or 6 per cent, or 8 per cent – they risk being left behind.
What I am describing here is very much like deterrence theory, a game in which expectations are key: public expectations about central bank policy, central bank expectations about the public’s response, expectations about expectations about expectations. Which is what makes so much of the current rhetoric in central bank circles, intended to sound reassuring, so distinctly unnerving.
It isn’t just the complacency about future inflation, or the apparent willingness to adopt more relaxed inflation targets, in which undershoots are banked and overshoots forgiven. It’s the talk of downgrading inflation altogether as an objective of policy, to take its place as one of several concomitant goals, alongside lower unemployment, greater equality and so on.
Indeed, it’s the common-sense demeanour of today’s central bankers, the softer, more humane image they have cultivated. All of which may simply combine to persuade the public, even subconsciously, that inflation is a one-way bet: that when push comes to shove central banks will give way, rather than enforce their targets. Which means we get inflation, or recession, or both.
By contrast, an obvious bastard, the kind of remote, flint-hearted zealot who the public believed would be willing to inflict a recession, in the cause of conquering inflation, without a second thought, might be just the sort most likely to avoid one – because he never let inflation, or inflation expectations, get off the ground in the first place.
The moral, in matters monetary as much as military: si vis pacem, para bellum. If you want peace, prepare for war.
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Andrew Coyne