Michael Roberts
Last week, US Federal Reserve Chairman Jay Powell appeared before the US Congress on inflation and the Federal Reserve’s monetary policy. He spooked financial markets when he appeared to say that the latest data on the economy would likely call for more interest rate hikes, and at a faster pace. Powell argued that although the headline inflation rate had declined, the “core” inflation rate, which excludes energy and food prices, was still “sticky.” Furthermore, the US labor market still looked exceptionally strong, justifying the need to monitor the impact of any wage increases. He again suggested that the Federal Reserve’s policy rate (which sets the floor for all other lending rates) would need to be raised further until wage costs are brought under control.
Again, Powell, like other central bank governors, claimed that inflation was being driven by “excess demand” and also by the risk that rising wages would cause a “wage-price” spiral. But there is plenty of evidence that it is not excessive demand or wage pressure that has caused inflation to accelerate. I have offered such proofs in several previous articles. AND in a recent note, I went through a long study by Joseph Stiglitz that gave comprehensive data showing that inflation is caused by shortages on the supply side, not “excess demand.”
Since then, more evidence has emerged to support that the offer is to blame. a recent document found that when the economy emerged from the lockdowns of the COVID pandemic and crisis, there was a shift toward buying more goods. However, the producers could not cope with this increase. “Our main finding is that the shift in consumer demand away from services towards goods can explain a large part of the increase in US inflation between the fourth quarter of 2019 and the fourth quarter of 2021. This reallocation shock of the Demand is inflationary because of the costs of increasing production in goods-producing sectors and because those sectors tend to have more flexible prices than those that produce services.
And there is more evidence that the inflationary increase was driven mainly by non-labor costs (raw materials, components and transport) and by strong increases in profit margins. Salary increases made the least contribution.
The latest data from the US on wage increases confirms that there is no “push push” inflation.
And this is not only in the United States. In the Eurozone, it is more evident that non-labor costs and benefits drove inflation rates. The ECB recently published an estimate of the contributions of profits, taxes and labor costs to eurozone inflation.
Even so, can it be argued that tighter monetary policy, i.e. raising interest rates to increase the cost of borrowing and reducing the money supply by selling off assets in the form of central bank bonds, will still can reduce inflation? Not according to the ECB’s own analysis. In one study, the ECB found that an interest rate increase of 1 percentage point only reduces inflation by 0.1 to 0.2 percentage points. The ECB also estimates that the largest negative year-on-year effect of rate increases on GDP will only materialize after nine quarters!
The supply situation is key to inflation. In particular, in the long run, it is the growth rate of productivity in any economy. If growth in output per employee slows or even declines, costs per unit of output will rise, forcing companies to try to raise prices. Other recent document argued that “industry-wide cost shocks and supply bottlenecks” they create the conditions for companies with some pricing power to raise prices to protect their profit margins. It becomes “sellers’ inflation.”
Productivity growth is key to inflation. In fact, there is a strong inverse correlation (0.45) between productivity growth and inflation rates over the past two decades.
Powell is now talking about raising rates faster and faster. But the impact of previous increases has barely affected inflation. And controlling the money supply doesn’t seem to have much of an effect on inflation, contrary to the view of monetarists. The Bank for International Settlements (BIS) is the international association of central banks worldwide. Its economists are staunch monetarists and free-market supporters of the Austrian School. In a recent study, the BIS found “a statistically and economically significant correlation in a number of countries between the growth of excess money in 2020 and average inflation in 2021 and 2020.” John Plender of the Financial Times, another expert from the Austrian School, concludes that “You don’t have to be a follower of the quantity theory of money to see that the buoyancy in US home and stock prices last year was caused substantially by too much money chasing too few assets.”
Take note of two things here. First, there is causation. As the BIS admits, “The debate over the direction of causation in the link between money and inflation has not been fully resolved. The observation that money growth today helps predict inflation tomorrow does not, in itself, imply causation. could be that “It was income, not money, that caused spending to rise, with developments in money balances acting as a signal.” But then the BIS goes on to argue that “causality is neither necessary nor sufficient for money to have information content useful for inflation, which is our focus here.” oh really? Of course it matters whether it is economic activity, output, and spending growth that drives the overall money supply, or vice versa.
Second, Plender points out that the increase in the money supply is associated with rising house prices and stock prices, not to mention the prices of goods and services. And that is the point. Strong growth in the money supply and low interest rates until the outbreak of the pandemic did not lead to higher prices and accelerating inflation in stores. Instead, the money supply fueled a credit boom expressed in a boom in real estate and financial assets.
What is missing from the monetarist argument is that changes in the money supply can also mean changes in the velocity of money, that is, the rate of turnover of the existing money supply. If the velocity of money falls, it means that cash holders do not spend it on goods and services, but accumulate it in deposits or invest in property and financial assets. So as the growth of the money supply accelerated in the first two decades of this century, the velocity of money fell as cash was used in financial and real estate speculation.
But keep in mind the change since the pandemic. The Federal Reserve has been tightening the money supply to control inflation. After exploding in 2020 during the pandemic crisis, the money supply is now contracting.
But instead, the velocity of that money supply is increasing, offsetting the impact of tighter monetary policy. That makes any tight monetary policy ineffective for inflation, but not necessarily for economic growth and employment. Federal Reserve policy will not work except to hasten a slide into economic recession. Researchers at the Cleveland Federal Reserve analyzed the most recent economic projections from the FOMC. Their model projects that the current FOMC unemployment forecast would reduce core PCE inflation to 2.75%, but only by 2025. And would be necessary a “deep recession to achieve” the 2.1% inflation projection that the Federal Reserve is looking for.
And now we have the collapse of the SVB as a result of the Federal Reserve’s interest rate hikes. see my note from last week. In fact, this may force the Federal Reserve to pause its plan to raise interest rates faster and faster. The Federal Reserve is being caught in a quandary: More rate hikes could mean more bank failures and recession; but stopping the increases means that the Federal Reserve has no instruments to deal with inflation.
The worst is yet to come for the so-called global South. If the Federal Reserve continues to raise rates, the US dollar will regain strength after the recent short pause (see chart below).
Total global debt is now more than $300 trillion, or 345% of global GDP, up from $255 trillion, or 320% of GDP, before the covid-19 pandemic. The more indebted the world becomes, the more sensitive it is to rate increases. To assess the combined effect of higher loans and rates, The Economist estimated the interest bill for businesses, households and governments in 58 countries. Together, these economies account for more than 90% of global GDP. In 2021, its interest bill stood at $10.4 trillion, or 12% of global GDP. By 2022 it had reached a whopping $13 trillion, or 14.5%. As much of the debt of the Global South economies is in dollars, an appreciation of the dollar relative to their own currencies is an additional burden. Developing economies now spend more on servicing foreign debt than on the health of their citizens!
So not only is recession on the agenda for the G7 economies, but debt defaults and crises are already beginning in ‘developing’ economies (eg Sri Lanka, Zambia, Pakistan, Egypt). .
Michael Roberts: A regular contributor to Without Permission, he is a British Marxist economist, who has worked for 30 years in the City of London as an economic analyst and publishes the blog The Next Recession.
Source: Translation: G. Buster
