Fighting the Last Inflation War

In the decade that followed the 2008 global financial crisis, some central banks overestimated the dangers of inflation and pursued unnecessarily tight monetary policies. In 2021, they fought the last war yet again, but this time by underestimating the risks of rising price pressures.

In 1955, then-US Federal Reserve Chair William McChesney Martin famously said that the Fed’s job was to take away the punch bowl “just when the party was really warming up,” rather than waiting until the revelers were drunk and raucous. Decades later, in the aftermath of the 1970s inflation, it became an article of faith among monetary policymakers that they should not wait until elevated inflation showed its face before reining in an overheating economy. Today, with inflation surging, they are developing a renewed appreciation for the punch-bowl metaphor.

During the decade that followed the 2008 global financial crisis, adherence to this time-honored practice arguably led some central banks to pursue unnecessarily tight monetary policies. In retrospect, they sometimes overestimated the danger of inflation.

In 2021, central bankers once again “fought the last war,” but this time by underestimating the danger of inflation as economic recovery began to run into capacity constraints. By the end of 2021, the US unemployment rate had dipped below 4%, and inflation, at 7%, had hit a 40-year high. The Fed, having earlier taken the optimistic view that any inflation would be transitory, must now play catch-up.

The experience of 2008-18 suggested that expansionary monetary policy could promote growth, and ultimately drive US unemployment below 4%, with few adverse effects on price stability and interest rates. This conclusion required no fundamental rethink of macroeconomic theory. Rather, it followed naturally from the proposition that the economy at that time was operating on the low, flat part of the “LM curve,” and the low, flat part of the Phillips curve (which otherwise asserts a clear tradeoff between unemployment and inflation).

Consider key examples during that ten-year period when policymakers and commentators overestimated the danger that monetary easing would fuel inflation.

The European Central Bank actually raised its policy interest rate in July 2008. Although it soon corrected its mistake, it then raised rates again in April-July 2011. Sweden’s Riksbank did the same, raising interest rates in 2008 (through September) and, more egregiously, again in 2010-11.

Even more obviously mistaken in 2010 was a famous letter to then-Fed Chair Ben Bernanke from a group of 24 economists, academics, and fund managers, opposing the monthly asset purchases, known as quantitative easing, then underway, and warning that QE would not promote employment, but rather “risk currency debasement and inflation.” As should have been clear at a time when unemployment still exceeded 9%, there was in fact no reason to fear that monetary stimulus would lead to excessive inflation. The consensus among economists is that the Fed’s aggressive monetary easing in response to the 2007-09 recession was fully justified.

Lastly, and more surprising to economists, was the 2016-18 period, when US GDP rose above its estimated potential and unemployment fell below 4%. In the past, this combination had signaled an overheating economy. So, it is understandable that the Fed raised interest rates from 2016 through the end of 2018. But, in the end, very little of the feared inflation materialized, suggesting in retrospect that the economy could have been allowed to “run hot” for longer. Apparently, the Phillips curve, if not dead, was supine.

Now inflation is back on its feet. It turns out that when demand increases faster than supply, inflation results, just as the textbooks say. But the Fed, not wishing to repeat its mistake of 2018, underestimated the danger in 2021.

In 2020, the COVID-19 pandemic caused a sharp recession, before large US monetary and fiscal stimulus drove the subsequent rapid recovery. Inflation remained absent, the textbooks would tell us, because the negative pandemic-induced shock to demand must initially have been larger than the negative shock to supply before the stimulus kicked in.

But there is also another, less orthodox, explanation. When an emergency or disaster strikes, causing a run on, say, toilet paper, only economists think the best response is to raise prices before inventories disappear. Consumers, retailers, and toilet-paper manufacturers perceive this viscerally as “price-gouging” and express moral disapproval, so prices remain unchanged. Later, when emergency conditions ease, manufacturers and retailers can raise their prices without attracting the same opprobrium, especially when costs are rising. Despite well-known shortages in 2020, the price of toilet paper did not rise until 2021.

If there is any truth to this hypothesis, then the recent 7% US inflation may have included some “catch-up” by firms. In that case, inflation could well moderate during the coming year.

In any case, the Fed should now take away the punch bowl. Rising inflation is not the only evidence that the US economy is overheating. GDP growth has been rapid, and the labor market is tight.

The Fed has almost ended QE, which hugely expanded its balance sheet. But removing the punch bowl means also raising interest rates, as the Fed is expected to start doing in March, and gradually offloading the unconventional assets, particularly mortgage-backed securities, that the Fed has accumulated on its balance sheet. The Bank of England has already begun to sell off some of the bonds it holds, including corporate debt.

Meanwhile, the ECB may still be fighting the last war. Unlike the Fed and the BOE, it has not yet begun to taper its own QE policy, let alone raise its interest rate, which is still -0.5%. The ECB may be trying to avoid repeating its mistakes of 2008-11 when it failed to sustain stimulus in the wake of the global financial crisis. (Admittedly, growth has not been as strong in Europe as in the United States.)

The tendency to fight the last war stems from human nature. Recent events are most salient in shaping people’s perceptions of how the world works. Central bankers can justify focusing more on these developments by pointing to rapid and fundamental changes in technology and society. But, as they are now realizing, a longer-term historical perspective offers wisdom derived from a wider variety of circumstances.