A Balanced Response to Inflation
February 9, 2022
By Joseph Stiglitz
Although it is anyone’s guess what will happen next with inflation, the data show that there is no reason to react rashly with large across-the-board interest-rate hikes. The economy is working through an unprecedented transition that could ultimately be a boon for workers; but only if policymakers let the process play out.
NEW YORK–Although some supply shortages were anticipated as the global economy reopened after the COVID-19 lockdowns, they have proved more pervasive, and less transitory, than had been hoped. In a market economy that is governed at least in part by the laws of supply and demand, one expects shortages to be reflected in prices. And when individual price increases are lumped together, we call that inflation, which is now at levels not seen for many years.
Nonetheless, my biggest concern is that central banks will overreact, raising interest rates excessively and hampering the nascent recovery. As always, those at the bottom of the income scale would suffer the most in this scenario.
Several things stand out in the latest data. First, the inflation rate has been volatile. Last month, the media made a big deal out of the 7% annual inflation rate in the United States, while failing to note that the December rate was little more than half that of the October rate. With no evidence of spiraling inflation, market expectations–reflected in the difference in returns on inflation-indexed and non-inflation-indexed bonds–have been duly muted.
One major source of higher inflation has been energy prices, which rose at a seasonally adjusted annual rate of 30% in 2021. There is a reason why these prices are excluded from “core inflation.” As the world moves away from fossil fuels–as it must to mitigate climate change–some transitional costs are likely, because investment in fossil fuels may decline faster than alternative supplies increase. But what we are seeing today is a naked exercise of oil producers’ market power. Knowing that their days are numbered, oil companies are reaping whatever returns they still can.
High gasoline prices can be a big political problem, because every commuter confronts them constantly. But it is a safe bet that once gasoline prices return to more familiar pre-COVID levels, they won’t be fueling any remaining inflation momentum. Again, sophisticated market observers already recognize this.
Another big issue is used-car prices, which have highlighted technical problems with how the consumer price index is constructed. Higher prices mean that sellers are better off vis-à-vis buyers. But the consumer price index in the US (unlike in other countries) captures only the buyer’s side. This points to another reason why inflation expectations have remained relatively stable: people know that higher used-car prices are a short-term aberration that reflects the semiconductor shortage currently limiting the supply of new cars. We know how to make cars and chips as well today as we did two years ago, so there is every reason to believe that these prices will fall, giving rise to measured deflation.
Moreover, given that a large proportion of today’s inflation stems from global issues–like chip shortages and the behavior of oil cartels–it is a gross exaggeration to blame inflation on excessive fiscal support in the US. Acting on its own, the US can have only a limited effect on global prices.
Yes, the US has slightly higher inflation than Europe; but it also has enjoyed stronger growth. US policies prevented a massive increase in poverty that might have occurred otherwise. Recognizing that the cost of doing too little would be huge, US policymakers did the right thing. Moreover, some of the wage and price increases reflect the healthy balancing of supply and demand. Higher prices are supposed to indicate scarcity, redirecting resources to “solve” the shortages. They do not signal a change in the economy’s overall productive capacity.
The pandemic did expose a lack of economic resilience. “Just-in-time” inventory systems work well as long as there is no systemic problem. But if A is needed to produce B, and B is needed to produce C, and so on, it is easy to see how even a small disruption can have outsize consequences.
Similarly, a market economy tends not to adapt so well to big changes like a near-complete shutdown followed by a restart. And that difficult transition came after decades of shortchanging workers, especially those at the bottom of the pay scale. It is no wonder that the US is experiencing a “Great Resignation,” with workers quitting their jobs to seek better opportunities. If the resulting reduction in labor supply translates into wage increases, it would begin to rectify decades of weak to nonexistent real (inflation-adjusted) wage growth.
By contrast, rushing to dampen demand every time wages start to increase is a surefire way to ensure that workers’ pay is ratcheted down over time. With the US Federal Reserve now considering a new policy stance, it is worth noting that periods of rapid structural change often call for a higher optimal inflation rate, owing to the downward nominal rigidities of wages and prices (meaning that what goes up rarely comes down). We are in such a period now, and we shouldn’t panic if inflation exceeds the central bank’s 2% target–a rate for which there is no economic justification.
Any honest account of current inflation must carry a big disclaimer: Because we haven’t been through something like this before, we can’t be sure of how things will evolve. Nor can we be sure what to make of the Great Resignation, though there is little doubt that workers at the bottom have plenty to be angry about. Many workers on the sidelines may be forced back to work once their cash reserves run out; but if they are disgruntled, that may well show up in the productivity figures.
This much we do know: A large across-the-board increase in interest rates is a cure worse than the disease. We should not attack a supply-side problem by lowering demand and increasing unemployment. That might dampen inflation if it is taken far enough, but it will also ruin people’s lives.
What we need instead are targeted structural and fiscal policies aimed at unblocking supply bottlenecks and helping people confront today’s realities. For example, food stamps for the needy should be indexed to the price of food, and energy (fuel) subsidies to the price of energy. Beyond that, a one-time “inflation adjustment” tax cut for lower- and middle-income households would help them through the post-pandemic transition. It could be financed by taxing the monopoly rents of the oil, technology, pharmaceutical, and other corporate giants that made a killing from the crisis.