The current disconnect between falling inflation and low “economic slack” is a sign that ‘economics 101’ no longer works, according to a report from Capital Economics published earlier this week (7 August).
In an analytical blog entitled Revisiting the case for ‘immaculate disinflation’, Neil Shearing, the firm’s group chief economist, pointed out that US CPI headline inflation has fallen from 9.1% in June to 3.2% at time of writing (10 August). Meanwhile, core inflation in the EU has fallen from 6.4% to 5.3%. While July CPI figures for the UK have not yet been released, the Bank of England expects inflation to fall from June’s 7.9% to 5% by the end of the year.
“The textbooks have a clear view of how this process is supposed to work: higher interest rates lead to weaker demand, which creates economic slack, which in turn leads to disinflation,” Shearing said. “Central banks have played their part, raising rates in the most aggressive tightening cycle since the last big war on inflation ended in the early 1980s.
“But… the recent run of good news on inflation has come against a backdrop of extremely strong labour markets.”
US unemployment has plateaued at approximately 3.5%, while eurozone unemployment rates have fallen to their lowest rate in 25 years at 6.6%. In the UK, unemployment also remains historically low at 4% which, as Shearing pointed out, suggests there has been “no increase in economic slack”.
In part, the economist said this is because “the approach to inflation that is taught in Economics 101 has been fatally undermined by structural shifts in economies and labour markets over the past 20 years”.
By this, he means there is no longer a dependable relationship between demand, supply, wages and prices, which therefore means central banks cannot “predict where inflation is heading and respond accordingly”.
Shearing said: “Economists and central bankers need a new framework for thinking about inflation that is not rooted in the Phillips Curve, that now-discredited model showing a relationship between unemployment and inflation.
“As for the recent declines in inflation… the pandemic and then the war in Ukraine caused one-off shocks to the level of prices of everything from food and energy to used cars that is now passing through.
“This has echoes of the period after the Second World War, when a combination of huge supply dislocation and the relaxation of price controls led to a short but sharp burst of inflation.”
A post-Covid world
Critically, however, Shearing referenced Nobel-Laureate economist Paul Krugman’s recent call for a new analytical framework in a post-Covid environment, given he believes inflation and output should be analysed at £an economy-wide level, rather than for individual goods and services”.
According to Capital Economics’ inflationary model, which the firm first set out last year, below-potential output means firms can produce any amount of goods at the current market price. But once the output surpasses its potential, the price asked for by companies to produce more goods increases significantly.
By the same token, shifts in demand for goods and services can be significant when output is below potential but will lead to relatively small price changes. After the output reaches its full potential, shifts in demand can only generate small changes in output but could significantly impact price fluctuations.
Shearing said this framework has so far shifted twice over the last two years. Firstly, following loose monetary policy and fiscal stimulus after the pandemic; and secondly, when the Russia-Ukraine war squeezed supply potential.
“As a result… output increased modestly but prices increased a lot,” Shearing explained.
“Crucially, this shifted economies…. to a place where small movements in demand create large moves in prices with little change in output. This may help to explain why inflation has fallen without the need for a large fall in output (or increase in economic slack).
“In addition, it is likely that policymakers have also had a helping hand from a recovery in aggregate supply as pandemic-related supply restrictions have ended and labour market participation and employment has rebounded.”
Now, Shearing said the key question for central banks is whether falling inflation remain sustainable without relying on economic slack – or big falls in output. He reasoned that this will mostly depend on labour markets.
He explained: “Wage growth in the eurozone and the UK has been much slower to fall and remains far too high for either the ECB’s or the Bank of England’s liking.
“The concern is that unless wage growth cools, so-called “second round” effects will lead to a renewed rise in inflation further down the line.”
Shearing said this can also be achieved without “injecting slack” into the labour market, given Capital Economics’ research suggests pressure to increase pay to fill vacancies is easing off.