Demand or Supply? That Is the Question!

With many Central Banks now more actively tightening monetary policy, financial markets have unsurprisingly been more unsettled in recent weeks. The dilemma for investors is obvious. Should they assume that policymakers are applying a gentle brake to a world economy that is barely breaching its speed limit and will now seamlessly guide it back to a more inflation-friendly speed? Or, are they slamming on the brakes far too hard, and far too early – and to mix the metaphors – now taking a sledgehammer to crack a nut?

To this scribe the risks are tilted toward the second scenario. There is little question that monetary policy is still accommodative and that a slow normalisation campaign is warranted as the world economy normalises in a likely post-pandemic adjustment phase. But a growing number of Central Banks appear to be of the view that inflationary pressures have been building because their monetary policies have been too loose. A more active tightening campaign is therefore deemed necessary in order to squeeze out these pressures. But as we argue in more detail below this strategy carries tremendous risks. And global economic and financial stability are in danger at present of being sacrificed somewhat unnecessarily at the altar of Central Banks' inflation-fighting credentials

This view is based on several messages from the analysis below. Firstly, that the inflationary pressures that have been building in recent months are globally - not nationally - rooted. Secondly, that those global pressures have largely been driven by COVID-related supply side congestion, not by excessively loose monetary policy and overheating demand. Thirdly, and to that last point, credit impulses in most major economies have moved into negative territory in recent months. That's not symptomatic of excessively loose monetary policy. Fourthly, nearly every major economy - including the US - is still operating below levels that would have been expected based on pre-pandemic trends. And that's not symptomatic of an overheating world economy. Finally, wage inflation in nearly every major economy is not yet even close to keeping pace with headline price inflation. Household purchasing power is therefore being significantly eroded even in the absence of tighter monetary policy and igniting recession risks as a result.

Globally-rooted supply side pressures

Let's start with those global roots and those supply-side roots. A recent paper from the Federal Reserve Bank of New York (see The Global Supply Side of Inflationary Pressures) assessed in some detail the recent evolution of inflationary pressures in the US and Euro Area. One of the key findings is that globally-rooted supply factors – including those that pertain to the price of oil - are very strongly associated with the levels of - and persistence of - recent producer price inflation across countries, as well as with consumer goods price inflation (see figures 1, 2 and 3 below). This is noteworthy because all major advanced countries have experienced a large rise in goods price inflation during the initial pandemic recovery phase. Services inflation in contrast has been more muted.

As the paper's authors additionally note if their analysis is accurate and the bulk of many major economies' inflation issues can be traced to global roots and to supply-side roots, it suggests that domestic monetary policy actions could have only a limited effect in containing inflationary pressures.

Figure 1: US goods price inflation has been highly correlated with goods price inflation elsewhere

Source: FRBNY, Haver Analytics. Drawn from 'The Global Supply Side of Inflationary Pressures,' Federal Reserve Bank of New York, January 28 2022.

Figure 2: Global factors are related to recent US CPI goods inflation

Source: FRBNY, Haver Analytics. Drawn from 'The Global Supply Side of Inflationary Pressures,' Federal Reserve Bank of New York, January 28 2022. GSCPI is the estimated contribution of global supply chain factors to US CPI goods price inflation. Additional contributions are estimated from oil supply factors and from both oil supply and demand factors.

Figure 3: Global factors are related to recent Euro Area CPI goods inflation

Source: FRBNY, Haver Analytics. Drawn from 'The Global Supply Side of Inflationary Pressures,' Federal Reserve Bank of New York, January 28 2022. GSCPI is the estimated contribution of global supply chain factors to Euro Area CPI goods price inflation. Additional contributions are estimated from oil supply factors and from both oil supply and demand factors.

What about demand

But what about demand? Surely that too has to have played a role in igniting price pressures across the world economy in recent months? The answer is yes it has, at least to some extent, and certainly if we look at relative demand patterns in recent months and how these have affected the path of core CPI inflation in various countries (see figure 4 below). The US, New Zealand and Sweden, for instance, whose domestic demand growth has been relatively strong during the pandemic period, have typically seen higher core inflation rates relative to, say, Japan, Spain and Switzerland, where domestic demand growth has been relatively weak.

Figure 4: Global inflation outcomes have been loosely related to the relative strength of domestic demand in recent quarters

Source: National sources, Haver Analytics

Digging into these cross-country comparisons a little further though reveals that other factors have also been responsible for the distribution of global inflation outcomes. One of these is inflation momentum. The starting position of core CPI inflation in January 2020, for example, just prior to the pandemic shock, does a pretty good job at explaining the overshoot or the undershoot of inflation compared with domestic demand (see figure 5 below).

Figure 5: Global inflation overshoots and undershoots (relative to demand) have been loosely related to pre-pandemic inflation level

Source: National sources, Haver Analytics. The predicted level of inflation is based on a simple linear regression of core inflation and domestic demand in each economy.

Equally - and in line with the supply-side leanings of the FRBNY analysis above - issues concerning labour markets and specifically weaker participation rates help explain why some economies – and the UK and US in particular – have experienced relatively high core inflation. Higher participation rates in economies such as Japan in the meantime additionally helps explain why that economy has seen relatively low core inflation.

Figure 6: Inflation outcomes have very loosely been related to labour supply issues

Source: National sources, Haver Analytics

By the same token it is no coincidence that those economies that have experienced relatively high – and volatile – levels of policy stringency during the pandemic era (e.g. lockdowns, work and school closures, travel bans etc.) and New Zealand in particular have experienced relatively high levels of core inflation. Equally, it should not be surprising that Japan, Switzerland and Denmark – all of whom have experienced relatively low levels and low volatility of policy stringency – have experienced relatively benign core inflation rates at the same time (see figure 7 below).

Figure 7: The level – and volatility - of lockdown stringency has also likely played a role in relative inflation outcomes

Source: National sources, Haver Analytics

This analysis very firmly suggests that policymakers ought to be addressing the chief causes of the world economy's inflation tensions, namely the COVID pandemic and the supply side congestion this has invoked. Central Bankers in the meantime ought to more specifically question whether tighter policies are warranted in order to choke off any residual price pressures that are being generated by easy credit and/or overheating demand.

On that first point concerning easy credit there is little evidence at present to suggest that monetary policy is too loose. Domestic credit growth in most major economies has been extremely benign in recent months and well below the pace of nominal GDP growth. That's why credit impulses - the change in the growth rate of credit growth relative to GDP - are negative at present in nearly every major economy (including China). This is not symptomatic of loose monetary policy, indeed at face value it would suggest policy is too restrictive!

Figure 8: Credit impulses are presently negative in most major economies

Meanwhile on the overheating front, while it's true that most countries' GDP growth rates are very strong at present and at face value well above what might constitute an inflation-friendly pace, this is mostly a function of straightforward catch-up arithmetic kicking in as a result of the steep plunge in output that unfolded in the early phase of the pandemic. If, instead, we drill into the latest estimated levels of GDP (in Q3 or Q4 2021) and compare these with what we would have expected based on pre-pandemic rates of output growth, nearly every major economy is operating at levels that imply a short-fall in aggregate demand (see figure 9 below). At the very least the analysis suggests it is difficult to argue that these economies are over-heating.

Figure 9: Latest GDP level relative to projected level based on pre-pandemic trend, %

Source: National sources, Haver Analytics

Of course this does not imply that as economies continue to recover from the pandemic that a monetary policy normalisation process would not be apt. But policymakers need to be mindful here that this recovery is already in jeopardy thanks to other growth-sapping factors that are now lurking beneath the surface. The first – and most obvious - is the supply-driven jump in inflation itself. The current pace of wage growth in the world's major economies is not even close at present to keeping pace with headline inflation. That means that real wage growth – a proxy for household purchasing power – is being severely squeezed (see figure 10 below for a US example). Even in the absence of tighter monetary policy that seems likely to derail consumer spending growth not least now that savings rates have already returned to pre-pandemic levels.

Secondly, fiscal policy is turning more restrictive in most major economies as the government spending that was incurred to prop up growth during the pandemic is phased out and as taxes are raised to pay down the debt that this additional spending has fuelled. Finally, world trade seems certain to decelerate too as consumer spending on goods drops back to more normal pre-pandemic levels and as a deleveraging process in China – usually a key motor for world trade – takes hold.

Figure 10: Real average hourly earnings growth in the US is negative

The bottom line? Inflationary pressures cannot be traced to loose domestic monetary policies. Global growth – and inflation - in the meantime seems destined to slow in the absence of tighter monetary policy. Very slow and carefully managed normalisation campaigns may still be apt. But policymakers should retain a much sharper focus on the crux of these matters, namely on the COVID pandemic, on vaccination campaigns, on re-opening their economies and more generally on allowing the supply fabric of the world economy to return to normal as quickly as possible.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.