After rising steadily for months, on Dec 10, the US government announced that inflation for November hit 6.8% — the highest in four decades — and sounded a louder warning for other economies whose health remains tied to the world’s largest.
From the perspective of Insead’s professor Pushan Dutt, the effective way to fight inflation is to hike rates quickly and not take a gradual approach over a longer period of time. This is because changes in the interest rates can only be felt by the real economy in six to 12 months’ time, while the economic cost of higher rates continues to weigh.
“The only way to accelerate the impact is to have a substantial increase in interest rates, but then you bring the interest rates back down,” says Dutt, the business school’s professor of economics and political science. He was speaking at a recent investment forum, Investival, organised by The Edge Singapore.
Paul Volcker, the US Federal Reserve chairman between 1979 and 1987, famously hiked rates rapidly to combat US inflation, which peaked at 14.8% in March 1980. From the time Volcker took office till June 1981, the Fed nearly doubled its key rate from 11.2% to 20%. The inflation was reined in, dropping down to below 3% by 1983. However, other aspects of the US economy were hit. For example, unemployment went above 10%.
On Dec 15, the US Fed announced that its priority is to tackle inflation and that it will hike rates three times in the coming 2022, two times in 2023, and three times in 2024. Jerome Powell, chairman of the Fed, also raised the possibility of withdrawing liquidity from the financial system before too long by reducing its massive balance sheet.
“One of the two big threats to getting back to maximum employment is actually high inflation,” said Powell at a briefing. The other threat, of course, is the pandemic. “What we need is another long expansion, like the ones we have been having over the last 40 years,” he said.
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Now, if rates are to be raised, debt, already at lofty levels, might increase further. However, if the borrowed money is channelled towards investments in education, healthcare and infrastructure, then “I would argue that … we can be a little bit more risky in terms of running up debt,” says Dutt.
He agrees with suggestions that the tapering of the quantitative easing (QE) programme will help in tempering inflation. However, the inflationary pressures this time round come more from supply chain shocks and less from over-excessive demand. Prices of various commodities such as lumber, oil, coal, iron, and so on, have gone through their respective upswings earlier this year because of supply issues, although they have all come off the peaks more recently.
Putting on his economist hat, Dutt notes that market prices going up will be met by businesses jumping in to meet the demand with greater supply. For example, after the initial pandemic months where there was a shortage of masks, many factories began to retool and reconfigure their production lines to produce vast quantities of masks, thereby bringing down prices from the initial spikes. “So they correct themselves,” he says.
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The same free-market norms of behaviour, however, cannot be applied that easily in other industries, for example, semiconductors, given how it costs billions over more than a year to build and equip a new plant. In any case, Dutt maintains that the inflationary situation now is a “transitory supply shock” and if further stimulus is held off, there will be a “natural decline” in demand.
Furthermore, actual inflation numbers carry less significance than expectations of inflation. What this means is that if consumers are bracing for high inflation, they will be demanding higher wages to make up for what they expect will be an erosion in their actual spending power. The higher wages will translate into higher fixed costs for businesses, which would then be nudged to raise prices to maintain or make up for margins they expect to come under pressure. By then, a self-reinforcing loop would be triggered and then “things get out of control”, says Dutt.
Zombies and bubbles
In the meantime, there is the lingering impact from the prolonged “money printing” which characterises this multi-year QE programme by the US: first to rescue financial institutions from the 2008 subprime crisis, followed by the need to support the economy from the fallout of the pandemic.
The excess funding available at low rates has allowed many firms — which would have otherwise gone bankrupt — to survive as they continue to have access to cheap credit. “This leads to the phenomenon of what is called zombie firms, which Japan has experienced for close to many decades,” says Dutt, warning that in the long run, productivity will be hurt as unproductive firms are allowed to go on instead of going out of business as conventional economic norms dictate.
The pandemic, with around nine million deaths worldwide thus far, has clearly extracted a hefty human toll. It has also thrown out some conventional assumptions, and accentuated the inequality gap between economies and within countries.
Back in October 2019, the International Monetary Fund projected that emerging economies will grow 4.6% in 2020, and advanced economies will creep up by just 1.7%. The pandemic struck in early 2020, sending entire economies into lockdowns, and resulting in the inevitable contraction. In June 2020, IMF revised its projections. Emerging economies were seen to contract by 1%, but actual 2020 GDP performance was a contraction of 2.2% instead.
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In contrast, advanced economies, according to the IMF in June 2020, was to plunge by 6.1%. Yet, these richer nations ended 2020 with a better-than-expected performance of –4.7% instead. “Advanced economies essentially had a lot of fiscal and monetary policy tools in their arsenal,” reasons Dutt. The US, for one, is spending the equivalent of a quarter of its GDP, while Singapore is spending nearly a fifth, to support the economy. In contrast, emerging economies continue to worry over debt and fiscal resources.
However, Dutt says with better availability of vaccines and higher vaccination rates, there is “light at the end of the tunnel”. The world is looking at a V-shaped recovery, with a projection of 6% growth for 2021, versus a contraction of 3.3% recorded for 2020. Come 2022, the world economy will ease off slightly but will still grow 4.9%. Advanced economies are seen to end 2021 at 5.6% growth, albeit from a low base, and continue to grow another 4.4% in 2022. Emerging economies, meanwhile, will end 2021 up 6.3% and continue with 5.2% in 2022. “We should not get too pessimistic,” he says.
Nevertheless, there are risks to watch out for. For one, the underlying theme of inequality remains, or will become more pronounced. “Covid was supposed to be the great unifier in the world, but it actually made visible lots of inequaliy, which exist across countries and across people within countries. We are going to see differences in recoveries,” says Dutt.
For example, employment rates of higher wage workers in the US have recovered and so have the middle-wage ones. The lower-wage workers, in contrast, are still suffering lower employment rates.
There are “huge differences” across sectors as well. For example, during the Global Financial Crisis, the durable goods sector in the US was hit, but services actually benefitted. The reverse is true in the current pandemic, where services took the biggest hit, says Dutt.
QE trap
In any case, policymakers need to keep in mind risks of new virus variants, with the notable delta variant, and more recently omicron, hogging headlines and keeping scientists in their laboratories. “If you let the virus rampage through a particular society, more variants might show up and they might sort of start escaping the vaccine protection,” he warns. Rising number of Covid-19 cases and expiring fiscal stimulus mean that growth rates on a whole for 2021 and 2022 might be overly optimistic, he adds.
Another worry is that while the US is very good at QE, as there is too much money looking for yield, creating markets and economies with bubbles. “Much of these asset prices, when they inflate, actually generates inequality because the wealthy actually hold most of the assets in an economy,” he explains.
This inequality could make things easier for populist politicians to start winning elections, whereby taking advantage of this inequality could lead to trade wars. Overall, all these scenarios could lead to lower growth, which ironically might lead to calls for more QE.
“We might have actually gotten stuck in this trap, where we’re always looking to central banks — the Federal Reserve, the European Central Bank — to step in and continually keep the economy going, and this is not sustainable,” says Dutt.
