For the past two years economists have been divided into two camps on how to tame inflation, which rose at the fastest rate in four decades in many countries.
‘Team transitory’ said inflation was due to supply-side shocks related to the pandemic and, later, the war in Ukraine. All supply-side shocks are transitory and eventually work themselves out of the system through base effects.
Hiking interest rates to address supply-side (or “cost-push”) inflation was a pointless exercise, a blunt instrument that would cause too much collateral damage. Interest rates only work when there is “demand-pull” inflation, or too much money chasing too few goods and services.
The correct policy responses in these circumstances were targeted fiscal and industrial policies to directly address the supply-side issues.
‘Team stagflation’, or team persistent, said high inflation in the US was due to too much stimulus. Stagflation refers to a dangerous cocktail of low growth (or stagnation) and high inflation.
In the wake of the pandemic-induced recession of 2020, the US implemented a $5-trillion stimulus that was delivered in three instalments: $2.2-trillion in March 2020, $900bn in December 2020 and $1.9-trillion in March 2021. According to this view, the correct policy response was to increase interest rates.
One study said unemployment would have to soar to 6.5% and stay there for two years to reduce inflation to the 2% target. Team transitory hit back and produced statistics that showed there was no “demand-pull” inflation in the US.
Also, inflation was a global phenomenon and prices had risen in other countries that had no bazooka stimulus packages, but the inflation spike lasted longer than expected. Team stagflation — the establishment or mainstream economists — declared victory.
Throughout this episode I was a card-carrying member of team transitory. I said Eskom had done the most effective job of decimating aggregate demand. There was significant spare capacity in the economy — too little money chasing too many goods and services.
Increasing rates in such an economy was the equivalent of a boxer punching an opponent who was already on the canvas. Inflation had lasted longer than expected because there were multiple and consecutive supply-side shocks.
In the US inflation peaked on its own at 9.1% in June 2022, less than three months after the Federal Reserve started increasing rates. By October 2023 it had fallen to 3.2%. The next print is expected to start with a two.
Inflation has tumbled in the US without an increase in unemployment, which is still at 3.7%. In the eurozone, inflation peaked at 10.6% in October 2022, less than three months after the European Central Bank started increasing rates. By October 2023 it had fallen to 2.9%.
The debate has now been settled in extra time, and team transitory is having a victory lap. Financial Times columnist Martin Wolf has referred to the US combination of high growth, low unemployment and falling inflation as “the immaculate disinflation”.
New York Times columnist and Nobel laureate Paul Krugman asked why so many economists got the inflation outlook so wrong. US economist James Galbraith describes the misdiagnosis of inflation as the latest episode in a long-running series of failures.
He says we should ask whether something is wrong with mainstream economics. “Mainstream economists should perhaps re-examine their core beliefs, or maybe we need a new mainstream altogether.”
Since disinflation had nothing to do with monetary policy settings, we should question the role of central banks and the groupthink that made them invent reasons to implement large, globally synchronised rate hikes when economics 101 showed they would have no effect on inflation.
Nobel laureate Joseph Stiglitz wrote: “Raising interest rates did not address the problem we faced: supply-side and demand-shift inflation. If anything, disinflation has happened despite central banks’ actions, not because of them.”
Will central bankers admit they were spectacularly wrong and reduce interest rates over the next year as fast as they increased them?
• Gqubule is research associate at the Social Policy Initiative.
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