With crude rallying back above $120, there seems to be no respite from the inflationary pressures affecting the global economy. Given this situation has resulted from both demand side (unprecedented stimulus – monetary and fiscal during the pandemic) and supply side factors (broken supply chains, war and Chinese lockdown), it isn’t particularly straightforward to assess how we are going to emerge out of this. Whilst central banks globally have begun raising interest rates, how effective they will be and how high do they need to go to rein in inflation and the implications on growth and unemployment are something the world’s best economists are grappling with? To help get our heads around this, we feature this interview by Martin Wolf of Oliver Blanchard, one of the more sensible macroeconomists around.
Wolf’s introduction of Blanchard goes: “Olivier Blanchard is among the world’s most respected macroeconomists. Of French nationality, he has been professor of economics at the Massachusetts Institute of Technology and chief economist of the International Monetary Fund. He is currently a senior fellow at the Peterson Institute for International Economics in Washington, DC.
He was one of the leading figures in the creation of “New Keynesian” economics in the 1980s and 1990s. More recently, he has argued that low long-term interest rates mean that it is safe to run larger fiscal deficits than previously thought.
Yet, in February 2021, he, too, warned of the threat of inflation, also stressing the excessive fiscal expansion.”
Wolf begins the interview by asking Blanchard about how we got here in the first place:
“I thought it obvious at the time that the amount of spending — the $1.9tn size of that bill, which came on top of a bill of nearly $900bn a few months before — was just too large. It was fairly obvious that this would lead to overheating of the economy. And where I was partly right and partly wrong is that I had this notion that unemployment would get very low, which it did, that there would be wage pressure and that prices would reflect the higher wages and that this would lead to more inflation. But I didn’t anticipate the role of the goods market, which is that in many sectors the strong demand led to supply disruptions and very large increases in prices. In the end, inflation came first not from where I would have expected it to come, which was wages, but rather from prices. People will say, these were accidents that could not have been anticipated, so you don’t get any points for your forecast. But I think that the increase in prices, the disruptions in supply chains, are very much the result of strong demand hitting supply walls. So, I would claim that I should get a few points for being right in February or March of 2021. Anybody could have come to the same conclusion. I’m happy I did. And then I would admit that inflation has been even higher than I expected, due to this problem in the goods market. A bit of boasting and a bit of humility.”
Blanchard then attributes the Fed being behind the curve in response to “His (Powell’s) staff drank the Kool-Aid, and he, not being a professional economist, could not easily second-guess them”
More importantly, what he reckons is likely to play out: “So, what will happen is, either we’ll have a lot more inflation if unemployment remains at 3.5 per cent, or we will have higher unemployment for a while if we are actually to get inflation down to two point something. Clearly, some of the inflation is going to go away on its own. But it will not get back to anything close to 2 or even 3 per cent at that low unemployment rate. So, more action will be needed. And then the big question is, how strong will aggregate demand be in the US? For the moment, the economy is running extremely hot and the vacancy rate is at levels that have never been seen before. But could a recession come without the Fed doing anything more than it intends to do? It’s not inconceivable.
…There is also an enormous fiscal consolidation right now. This will clearly decrease demand, regardless of monetary policy. Yet the reason it’s not obvious that there’ll be a decrease in demand is that there was this enormous accumulation of savings and it’s largely not yet spent. Also, the states received a lot of money in the $1.9tn fiscal package. They haven’t spent much of it either. Maybe somebody smarter than me could decide how it’s going to play out, but it is not inconceivable that the economy will slow down on its own quite a bit. Unemployment would then increase, and this would decrease the pressure on inflation.”
But he is more sanguine about the financial system which he reckons is much stronger unlike in past crises: “When you say there is turmoil in financial markets, what I see is that there is a large decrease in stock prices and an increase in interest rates. That’s how the monetary mechanism works….It’s monetary policy working via market anticipation of higher rates to come. Is this going to lead to financial trouble? I’m not a specialist in financial balance sheets, but what I read from the stress tests and other studies is that the financial system can take it.”
Where he clearly stands out in his opinion is that this is just a ‘bump’ and we will revert to the low interest rate regime soon after: “I think there’s a tendency for markets to focus on the current, on the present and extrapolate it forever. But if I look at the factors behind the decline in real interest rates since the mid-1980s, none of them seems about to turn around, except perhaps one, which is investment. Suppose that there were a large increase in public investment in the US, because we’ve realised we have to do something about global warming and in Europe, for the same reason. So, this would increase investment. That would increase the neutral real rate of interest. So, I can think of a new world in which public investment, and perhaps private investment as well, is much higher in the US and Europe. How high? I don’t think terribly high. But I would distinguish between the fact that we’re going to have a period of higher real rates, to slow down inflation, and the question whether we then go back to the same low real rates as before or a bit higher ones.”
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