The Blame Game

Bank of England policymakers have been slammed by UK newspapers in recent days for 'being asleep at the wheel'. Spiralling inflation, a 'cost-of-living crisis', a borrowing binge and an overheating labour market are being specifically pinned on lax UK monetary policy. And last week's UK data flow showing a further big jump in inflation, a steeper than expected drop in the unemployment rate and a record high for job vacancies have added more grease to the media's wheels.

But are these criticisms really justified? Well the answer is not quite, and for a number of reasons. The most straightforward reason being that these criticisms are not just being levelled at the BoE. They're also directed at the Fed, the BoC, RBA, ECB, and at many other central banks besides. In other words, many of these issues are globally-rooted and don't have their origins in lax domestic monetary policy.

Global roots

On the other hand, perhaps all of these central banks have been similarly asleep at the wheel during this period? Global monetary policy settings may have been far too loose for too long, particularly during the pandemic period. This could have generated too much money, excessive private sector leverage, and soaring demand. This could have now yielded outsized price pressures, wage price spirals thanks to overheating labour markets and dislodged inflation expectations to boot. If this isn't a wake-up call for policymakers to tighten monetary policy swiftly and aggressively and squeeze these excesses out of the system, then what is?

However, this global narrative and policy prescription doesn't quite hit the nail on the head either. There's no evidence – at the global level – for rampant money supply growth, for excess private sector leverage, or for economic activity more generally that's overheating. Price pressures have been, and still are, emerging due to acute supply side shortages that can mostly be traced to the pandemic or, more recently, to the conflict in Ukraine and China's zero COVID policy. And while a recovery in global demand has admittedly amplified these pressures, it has been fiscal policy – not monetary policy – that's been playing the supporting role.

All things considered, if that analysis is accurate, shouldn't monetary policy now play a bigger role in ameliorating these price pressures and, at the very least, preventing a bad situation from getting worse? This scribe is dubious. If loose and unorthodox monetary policies throughout the post-financial-crisis era failed to generate any consumer price inflation, and isn't really responsible for high inflation levels at present, why on earth should we expect tighter monetary policy to play a restraining role now?

More appropriate policy tools

Fighting the current combination of weak growth and high inflation with higher interest rates will not restore the supply fabric of the world economy not least now that most governments are tightening their fiscal stance at the same time. Surely a far more apt policy response (which admittedly the UK government is leaning toward) would be to use the levers of fiscal policy to alleviate supply-side shortages (e.g. in energy markets), increase an economy's production capacity and shore up the purchasing power of households and companies. By raising the cost of borrowing, tighter monetary policy will impede a supply side investment drive and further derail private sector purchasing power. As such, central banks may well make a bad situation even worse if they were to more actively respond to the pressures facing them from so many opinion formers in the media.

In what follows, we take a look at a few charts accompanied with (mostly) brief commentary reinforcing these messages.

The first chart in figure 1 below shows the strong link between commodity prices and consumer price inflation in the advanced economies over recent years. In short, consumer prices have been rising because input cost pressures have been rising.

Figure 1: Higher commodity costs have pushed up consumer price inflation

Figure 2 shows moreover that the roots of these recent commodity price pressures lie in the unusual nature of economic activity that's unfolded during (and after) the pandemic. It suggests a strong link between economic data surprises and commodity prices. Positive data surprises tend to be met with rising commodity prices and vice versa. So the chart suggests that rising commodity prices over recent months coincided with a large wave and subsequently by a smaller wave of stronger-than-expected global economic data.

Figure 2: Commodity prices were driven higher by relative demand shifts

Supply or demand?

Does that mean that unexpectedly strong global demand –not supply side restraint – have been responsible for rising commodity prices? Not so fast! Overall output levels at the start of 2022 were not that much higher than at the start of 2020. Prior to the pandemic output was expected to have easily surpassed those levels by now.

Instead, the chart implies that rolling waves of lockdowns in various major economies elicited unusually strong global growth in spending on goods (and unusually weak demand for domestic services). Given the highly interlinked nature of global supply chains that met with an unexpectedly strong global production response at the same time. Yet, given the global nature of that demand and supply, this response was choked by those same lockdown restrictions. And it is this mismatch that elicited a robust price response.

It would be very hard to argue that super-loose monetary policy played a big contributing role in these dynamics. It is fair to argue, however, that fiscal policy offered some reinforcement.

The role of fiscal policy

Indeed, the role of fiscal policy in this saga should not be underestimated. Figures 3, 4 and 5 below illustrate the key financial balances - the difference between income and spending - of the three key sectors (private, government and overseas) of the UK, Euro Area and US economies.

Analysing the broad gyrations of these balances can be fruitful. For example, some economists (though not many!) spotted how the triple deficits in these sector balances in the US and UK (and several other) economies in the mid-2000s posed a significant risk to the world economy. The combination of a high and growing current account deficit that was larger than the government sector deficit in the US and UK meant that the private sector was moving towards a net borrowing position (from surplus to deficit) as a housing bubble – amplified by loose monetary policy – developed. This was an unsustainable combination. And this helped sow the seeds of the financial crisis that followed.

Today, however, triple deficits do not exists. Instead a massive public sector re-leveraging effort (i.e. massive fiscal stimulus) has – until recently – been absorbed by a big de-leveraging in the private sector (i.e. a growing private sector savings surplus) and - in the case of the UK and US - little change in the overseas (i.e. current account) balance.

It is certainly reasonable to conclude that low interest rates and quantitative easing policies helped to facilitate this fiscal expansion. And without that policy combination there surely would have been a devastating collapse in aggregate demand.

But it is not fair to conclude that loose monetary policy ignited the fires, sent the wheels of banking credit spinning far too fast, and in doing so propelled private sector debt levels and external deficits to unsustainably high levels.

Figure 3: Fiscal policy has been in the driving seat of the Euro area economy in recent years

Figure 4: Fiscal policy has been in the driving seat of the UK economy in recent years

Figure 5: Fiscal policy has been in the driving seat of the US economy in recent years

What overheating?

As we've articulated already, however, there are still many fretting that this extraordinary fiscal activism during the pandemic era and the unorthodox monetary policies that accompanied this have still gone far too far. They typically point to the broadening of price and wage pressures of late and make a polite nod to "overheating" at the same time.

But on that nod to overheating, where is the evidence? Capacity utilisation rates – a gauge of the mismatch between demand and supply – are below normal levels in every major economy at present. This is symptomatic of a shortfall in demand, not an underlying excess.

It's certainly true that measured unemployment rates have dropped below normal, suggesting that some labour markets might be hot. And that chimes with soaring job vacancies and rising wage pressures to boot.

But there are many other labour market indicators that do not chime so easily with that story. Gauges of hours worked, for example, and overall employment levels are still mostly below pre-pandemic levels in the world's major economies (see figure 7 below). Measured with reference to their populations, this pace of employment growth would suggest there is still ample spare capacity that can be tapped. The key issue here is that participation rates – the proportion of people available and looking for regular work – have fallen. Hangovers from the pandemic (and possibly Brexit-related bottlenecks in the UK) mean the supply side of the labour market is not functioning as well as it used to.

It's certainly true that measured unemployment rates have dropped below normal, suggesting that some labour markets might be hot. And that chimes with soaring job vacancies and rising wage pressures to boot.

But there are many other labour market indicators that do not chime so easily with that story. Gauges of hours worked, for example, and overall employment levels are still mostly below pre-pandemic levels in the world's major economies (see figure 7 below). Measured with reference to their populations, this pace of employment growth would suggest there is still ample spare capacity that can be tapped. The key issue here is that participation rates – the proportion of people available and looking for regular work – have fallen. Hangovers from the pandemic (and possibly Brexit-related bottlenecks in the UK) mean the supply side of the labour market is not functioning as well as it used to.

Figure 6: Employment levels in most major economies have yet to surpass pre-pandemic levels

What do various companies have to say about this? Are they reporting surging demand growth and a new-found ability to raise their prices as a result? Well, no! Global survey evidence on this is admittedly quite thin. But the US Atlanta Fed's Business Expectations Survey asks American firms to state the influence of sales levels on prices over the next 12 months. The latest survey for May this year shows that expected price pressures due to sales have actually declined from a peak a few months ago (figure 7). That's not consistent with an overheating economy.

Figure 7: Evidence from the US that excess demand is driving up prices is thin

Expectations and wages

The reasoned responses to this line of thinking – particularly from more hawkish central bankers – is firstly that monetary policy acts with a long and variable lag. Monetary policy has been calibrated in recent months to shore up demand during the pandemic. Acting now to cool economic growth is prudent during the early stages of a pandemic recovery, not least if policy settings are still very loose. And secondly, while global supply side shocks are certainly responsible for escalating price pressures, the levers of monetary policy can still be used to fend off "second-round" effects from higher inflation expectations and higher wages.

No argument with the first of those refrains. Monetary policy does operate with long and variable lags. Indeed some might say far too long and far too variable. And monetary policy has been calibrated to be loose - though exactly how loose is clearly subject to much debate! However, given the degree to which consumer confidence surveys – usually reliable leading indicators of the economy - have been plummeting in recent weeks – it seems curious that some policymakers retain such certainty that policy brakes still need to be applied (see figure 8).

Figure 8: Consumer sentiment has slumped in many major economies in recent weeks

It is the "second-round" effects of these policy ambitions that are even more troubling however. For there is very little evidence – to the relief of dovish policymakers – that medium-term inflation expectations have become unmoored. Market-based and survey-based measures in Canada, the UK and the US have moved up a little from their pandemic-induced recession lows. But current levels do not look unusually high relative to the norms of the last twenty years (see figures 9 and 10 below).

Figure 9: UK and Canadian long-term inflation expectations are anchored

Figure 10: US long-term inflation expectations are anchored

The impotence of monetary policy

How about wages? These are clearly building though they are mostly following (not leading) price inflation and are certainly not yet keeping pace with it (i.e. real wages are falling). The more significant point on this though concerns the ability of central banks to lean on wage (and price) inflation. Without getting into all the grisly details, the textbook Phillips curve model – one of the main workhorse models of macroeconomics – seems to be broken (see figure 11). There are all sorts of reasons for this. But the simple idea that levers of monetary policy can be pulled to slow an economy to a rate that drives unemployment up which then drags wage and consumer price inflation down does not stand up to any empirical scrutiny (see figure 11 below).

Figure 11: Where is the UK Phillips Curve?

In closing, the media critics are wrong. The current state of the world economy cannot be pinned on loose monetary policy. The problem can't be solved by a tighter monetary policy either. All these problems remain rooted in disrupted global supply chains and the higher prices these have yielded. Combatting supply bottlenecks by pulling the levers of spending and taxation are a far more prudent policy choice at present. And the reasons for monetary policy dysfunction over recent years more generally need to be more fully understood before aimlessly destroying companies, jobs, livelihoods and living standards in a futile attempt to bring "inflation" under control.

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