Inflation is the only signal the post-Covid boom will hear

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Inflation is the only signal the post-Covid boom will hear


The economy previously offered many metrics that purported to show when growing economies were approaching some sort of speed limit. But increasingly, inflation is the only one taken seriously.

A sustained price spike would likely convince policymakers that it is time to put the brakes on expansionary measures adopted during the pandemic, such as high public spending or low borrowing costs. This is why Tuesday’s US consumer price data will be so closely watched – even if it will take more than a month to change your mind.

The problem of yesterday – or the problem of tomorrow?

Inflation has been a pressing problem in the rich world for decades

Source: Organization for Economic Co-operation and Development

Meanwhile – as part of a profound shift in economic thinking that has accelerated over the past year – a whole host of other metrics that were once relied on to signal problems ahead are in disgrace. .

Budget deficits and public debt were thought to flash a warning sign at certain levels – until many countries exceeded those limits, especially last year, without collapsing. Estimates of full employment, or the greatest number of jobs an economy could create without overheating, have been shown to be wrong.

Measures of the so-called “output gap” are meant to capture how close an economy has come to maximum capacity – but many analysts have concluded that they are relying too much on the recent past to be a useful guide. .

Pivot of humility

Dropping or minimizing all of these criteria means officials are less likely to take the kind of preemptive action that has stifled expansions in the past.

The turn is also equivalent to a pivot towards humility, in a profession which is not known for it. Economists used to offer their predictions as the basis of a policy. They need to recognize that the future is full of things they just don’t know.

“The influence of long-term projections has evaporated, and that’s a very good thing,” says James Galbraith, professor of economics at the University of Texas. “You design policies to deal with the problems you face. If they have consequences later, you address them later. “

This philosophy underpins the Federal Reserve’s new interest rate framework. In the last decade, the central bank began to increase borrowing costs even though inflation was subdued and unemployment was still around 5% after the financial crisis.

Now Fed officials do admit that this was a mistake because falling unemployment did not trigger a spike in prices. And now they say they will base their policy on what really happened in the economy, rather than what should happen next.

Space to run

The decade before Covid-19 showed that the US economy could continue to create jobs without triggering inflation

Source: Bureau of Labor Statistics

Three times in the past month, Federal Reserve Governor Lael Brainard contrasted “results” with “outlook” – and said Fed policy will be based on the former, not the second.

Speed ​​limits have also been redesigned in the area of ​​tax policy.

Budget deficits and the national debt as a share of the economy were the benchmarks. The European Union has imposed deficit ceilings of 3%. Economists Carmen Reinhart and Ken Rogoff, in a study from ten years ago, argued that debt at 90% of GDP was a dangerous tipping point.

This type of thinking led to austerity policies after the initial shock of the 2008 financial crisis – and the result was a weak recovery. But the budget forecast tended to be too pessimistic because it did not predict that interest rates would stay low.

Wrong path

The CBO has consistently overestimated government borrowing costs

Source: Congressional Budget Office

In the pandemic, governments have been more willing to spend, especially in the United States, President Joe Biden is pushing measures worth more than $ 5 trillion in its first year – from fuel to what already appears to be a faster rebound in the economy.

How hot?

In some ways, the new approach aligns with the school of thought called modern monetary theory. MMT says governments have the option of reviving their economies with budget spending, and argues that inflation – rather than deficit or debt levels – is the measure fiscal authorities need to watch.

“One thing the mainstream has figured out is to allow the economy to run a bit more,” says Scott Fullwiler, MMT economist and associate professor at the University of Missouri-Kansas City. “This is what we have been looking for for decades.”

Unfortunately, Fullwiler says, economists haven’t paid enough attention to the question of what a safe top speed would be – and too focused on central banks, even though it’s now fiscal policy that is. at the origin of the recoveries.

“The economic profession in general has a far-reaching ability to determine how well the economy can perform,” he says. He would have better answers now “if economists had worked on fiscal policy frameworks to stabilize the economy and keep inflation low, instead of optimal monetary policy, which is basically out of the question. about ”.

‘Absurd output gaps’

In the United States, opponents of Biden’s spending have cited the “output gap” – the difference between the goods and services an economy actually produces and the maximum it could sustainably manage.

Watch out for the gap

The US economy has grown below its potential since 1980

Source: CBO Economic Outlook, February 2021

Former Treasury Secretary Larry Summers and the Committee for a Responsible Federal Budget, for example, both argued that last month’s stimulus bill was much bigger than needed to close that deficit – and risked triggering inflation as a result.

But many analysts are skeptical of the measure. Robin Brooks, chief economist at the Institute of International Finance, has been campaigning against “absurd output gaps” for years.

The output gap is “an extremely important concept” that underlies all major policy calls, he says. “No one knows how to measure it.”

Output gaps depend on estimates of the potential of an economy. A small deficit means production is expected to be approaching its speed limits, and trying to speed it up could trigger inflation.

But Brooks says the potential is often calculated just by looking at what has happened in the recent past. He says that when a country has been underperforming for an extended period, like Italy in recent decades, the result is that its potential is degraded as well – which effectively limits how good things should be allowed. .

Plus de Slack?

Output gap in Q4 2020 as a share of potential GDP

In a February report, economists at Goldman Sachs tried another method of measurement and concluded that output gaps in major economies between Italy and the United States were likely larger at the end of the year. later than official estimates suggested – meaning there was “,” Less risk of inflation and a stronger case for expansionary policy.

Since then, the US recovery has accelerated, surprising many analysts.

Read more: US jobs are coming back, employers and economists surprising

Galbraith, who was director of the Congressional Joint Economic Committee during the recession of the early 1980s, says emergencies are not a good time for policymakers to attempt to forecast accurately.

“You’re not trying to calculate these things,” he says. “You throw as many as you need, and more. And then, if it turns out that you are doing too much – which is unlikely – you reduce it.

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