Debt-Management Constraint Points to Higher Inflation Strategy
It should come as little surprise that we think the golden age of inflation targeting is ending. Too many of the factors underpinning that regime have changed. And inflation at 2.0% would make it very difficult to generate enough financial repression to help manage current debt levels.
The debt-management constraint helps explain why widespread Japanification is unlikely. Unless countries are willing to accept perpetual negative interest rates, managing high debt in a zero-inflation, low-growth world is an arduous task. Moreover, it’s not clear that other democracies possess the cohesive social structures and relatively low levels of inequality that have allowed Japanese society to cope with a sustained period of stagnation. The political challenge would be even greater with populism on the rise.
That leaves the two higher-inflation scenarios. Double-digit inflation is highly disruptive, unpopular and, as the UK historical record demonstrates, unusual. There is no support for very high levels of inflation, and we regard the 1970s redux scenario as unlikely—though inflation could, of course, temporarily overshoot to very high levels as the world transitions from one regime to another.
The regime that offers the best template for coming years is the post-WW2 period. Then, as now, fiscal policy gained dominance, and containing inflation slipped down the pecking order as governments began to pursue broader objectives. There was also widespread use of financial repression to help manage government debt—and “financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.”* Crucially, as former Chair of the US Federal Reserve (the Fed) Arthur Burns noted in 1979,† inflation at these sorts of levels is still low enough to be seen as an “acceptable” price to pay as society starts to pursue broader objectives.
Policy Choices Will Shape the Inflation Outcome
Does this mean that central banks will become cheerleaders for this new, modestly higher inflation regime? That’s unlikely.
Several prominent economists have made the case for higher inflation targets, and the Fed has adopted a new average inflation-targeting strategy—albeit one that’s still anchored by a focus on long-run inflation expectations. But focusing on publicly stated targets misses the point. Few (if any) historical episodes of high inflation started out as deliberate attempts to drive the price level higher. Instead, inflation arose indirectly as policymakers pursued other goals. We expect the same thing to happen in coming years.
Just as in the 1960s and 1970s, it’s hard to see how central banks can avoid being caught up in these shifting “philosophic and political currents,” as Arthur Burns called them. The temptation to bend a little, in order to accommodate the prevailing political winds and yet still stay in the game, will be great.
The new regime is unlikely to be a carbon copy of the double-digit inflation environment that emerged in the 1970s. A more probable template is the financial repression era that ran from WW2 through the 1960s. But some elements of the backdrop today are clearly different. Notably, economic growth was far stronger in the immediate postwar years than it is now. That has clear ramifications for hitting some of those alternative objectives. For example, to drive debt/GDP ratios down, interest rates need to be lower and/or inflation higher than they were during the earlier financial repression period. That sort of uncomfortable arithmetic reinforces our conviction that, in the end, the political landscape, and the policy choices this entails, will open the door to higher inflation.
