Sacrificing growth to fight inflation

Sacrificing growth to fight inflation

Risking a mild recession today rather than a severe depression tomorrow.

For more than thirty years, inflation being low and not very volatile, those responsible for economic policy believed that they had definitively solved one part of the problem and that it was enough for them to concentrate on the other. When the economy fell into recession, the obvious reaction was to ease economic policy, particularly monetary policy, to support demand and employment without fear of price slippage.

Now the problem is quite different. Inflation continues to rise and is close to 10% in the euro zone. After an exceptional acceleration in 2021, economic growth has slowed sharply. Moreover, as the war in Ukraine has amplified the energy crisis to the point of raising fears of rationing next winter, the risk of recession increases. This time, the two objectives call for opposite reactions from economic policy. Fighting inflation requires monetary tightening, which will weigh on growth and cause unemployment to rise.

Everything indicates that the Europeans are as anxious as the Americans by the surge in prices.

Thus, a choice must be made between price stability or employment stability. Finding the right answer requires considering the nature of the inflation shock and the distribution of costs.

In 2020, the global economy was shut down to stop the circulation of the coronavirus. It was the deepest recession in modern history. The rebound was spectacular, but this result was not self-evident. Many feared a soft recovery, with relapses, or no recovery at all. Inflation concerns were non-existent. However, in a few months, inflation imposed itself as the main problem.

A striking illustration is given by a poll conducted by Gallup since the beginning of the 1980s among a panel of Americans. They have to rank the economic problems in order of severity. For a long time, inflation was almost never cited as a concern. Today, about a quarter of respondents see inflation as a major problem. Everything indicates that the Europeans are as anxious as the Americans by the surge in prices.

“Infl’action”, reaction

However, there are differences between the two areas. In the United States, around 30% of inflation comes from energy, the rest resulting from the strength of demand for non-energy goods and services. In the euro zone, this share exceeds 50%. Simplifying, one would be tempted to say that US inflation is due to excess demand, while European inflation is mainly the result of supply problems. This distinction is important because monetary policy can certainly affect household consumption or business investment but has no direct influence on the production and distribution of energy.

Without a strong reaction, the central banks would lose all credibility with regard to their mandate fixing the inflation target at 2%.

Now, the change in consumer psychology requires all central bankers to aim for disinflation without delay. There will inevitably be a cost in terms of growth or lost jobs, but it must be weighed against the expected benefits in the longer term. Experience shows that in general, when it comes to tightening monetary policy, central bankers opt for gradualism. This is no longer the case.

Without a strong reaction, the central banks would lose all credibility with regard to their mandate fixing the inflation target at 2%. Households could be led to think that 10% inflation is a new permanent regime, adjust their wage demands accordingly, leading to a spiral between prices and wages. Such a situation occurred in the 1970s. Only a serious economic crisis then made it possible to reduce inflation expectations. In 2022, the sacrifice therefore amounts to risking a small recession today rather than a severe recession tomorrow.

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