Some Global Inflation Perspectives

Central bankers would be the first to admit that domestic monetary policy is a blunt tool for steering economic growth and inflation. Alan Greenspan famously observed that setting policy can be like driving a car while looking in the rear-view mirror. He noted too that arriving sufficiently early “in order to take to away the punch bowl just as the party gets going” is often equally, if not more, challenging.

To extend these metaphors a little further a big problem at present concerns the image in that rear view which is shrouded in fog. In the meantime there is much uncertainty about how many guests have arrived at the party. Even more debatable is whether the punch bowl that's been provided actually contains any punch!

To elaborate on this let's look at a few charts. The first of these suggest the world economy's current inflation tensions are mainly rooted in global supply-side factors. Specifically figures 1 and 2 below show that higher commodity prices in recent months have been mostly responsible for the burst of positive global inflation surprises. That's incidentally as true in the US as it is in, say, Australia. Insofar as higher commodity prices are rooted in global supply-chain bottlenecks that have been choked by both the COVID pandemic and the Russia/Ukraine crisis combatting these inflation tensions via tighter domestic monetary policy will be challenging to say the least.

Figure 1: Inflation surprises in the G10 have been heavily driven by moves in commodity prices

Figure 2: Inflation surprises in emerging economies have been heavily driven by moves in commodity prices

This is not to deny the role that loose policy settings have played in igniting domestic demand and stoking price pressures, including – to some extent – commodity price pressures. The key question though concerns the degree. At face value latest estimates – and forecasts - for the output gap – the difference between an economy's output and its supply side potential – suggest that demand has outstripped supply in most major economies in recent months. Similar conclusions can be drawn from falling unemployment rates and rising wage inflation. And as figure 3 below suggests this mismatch between demand and supply has had some bearing on inflation outcomes. Insofar as both fiscal and monetary accommodation have been responsible for this it clearly behoves policymakers to tighten things up and choke off domestic demand.

But there are some big problems with this analysis. Firstly, recalling our metaphor above about the fog in the rear view mirror, estimates of output gaps and equilibrium unemployment rates are notoriously imprecise. That's partly because economic data are highly susceptible to revisions. But it's also because of the difficulties in estimating an economy's – or labour market's – potential supply. This is especially so at present given the degree to which both the pandemic and the crisis in Ukraine have been restricting the supply of key factors of production, including commodities and labour.

Figure 3: Inflation has been responding to the strength of demand relative to the economy's potential supply

A further reason to be cautious about a swift removal of policy accommodation concerns the underlying strength of demand at present. As figure 4 below suggests, domestic demand in most major economies has certainly recovered a lot of the ground that it lost during the pandemic era in recent quarters. But at the end of 2021 it was only in the United States where that level of demand was appreciably above its pre-COVID level. Furthermore there is scant evidence to suggest that demand, even in the US, has been driven by excess private sector credit growth (i.e. excessively loose monetary policy). Rather, government borrowing (i.e. loose fiscal policy) has been in the driving seat during the last couple of years, at least until quite recently.

Figure 4: Domestic demand in major economies is not that strong relative to pre-COVID norms

A final point to keep in mind is that many of the more forward looking surveys are now pointing to a fairly ugly economic environment in the immediate weeks ahead. Consumer confidence levels in most of these major economies in particular have slumped to levels that would typically be associated with recession. And as figures 5 and 6 illustrate respectively for the US and UK, that again offers a firm reminder that output gap estimates can quickly become quite dated as a signal for monetary policy purposes.

Figure 5: US consumer confidence (measured by the Michigan survey) has slumped

Figure 6: UK consumer confidence has slumped

Admittedly not all the news-flow about demand is negative at present. Consumer confidence is weak partly because inflation is high. And those confidence gauges that are more heavily tilted toward labour market conditions (e.g. the Conference Board's index in the US) have held up relatively well. Also, as discussed in Some Techno-Optimism, capex intentions are relatively high particularly in the technology space. And that bodes well for productivity growth in the period ahead. Still, that too ought to carry a warning signal for policymakers to tread carefully. Expanding capacity and beefing up efficiency are exactly what are needed if the supply fabric of the world economy has been impaired. And raising the cost of capital via tighter monetary policy may not be the most prudent policy choice against that backdrop. The fog, after all, is still very thick and the party's numbers could start to dwindle very swiftly if the punch bowl is withdrawn too soon.

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