We’re at that point in the economic cycle where officials are comfortable to admit they’ve made mistakes.
Central bankers are happy to talk about their forecast errors.
And the International Monetary Fund is publishing work that explains why it failed to predict the surge in inflation in recent years.
What can we learn from it?
A debate that’s getting ugly
It’s been obvious to anyone watching that economists are having a spirited debate about inflation at the moment.
They’ve been arguing about its origins, how it’s spread through economies, who it’s impacting the most, and how long it could take to retreat.
But the debate has been getting nasty in some corners too, especially over the question of profits.
Have any companies been using the cover of inflation to make excess profits? Has extreme profit-taking contributed to any inflationary dynamics?
According to some economists in Australia, it’s the height of idiocy and bias to entertain such questions.
But in Europe, central bank officials have been willing to turn their attention to the topic and treat it seriously.
For example, in January, Portugal’s central bank governor Mário Centeno warned profit-margin growth in Portugal had increased so much that it could undermine efforts to bring inflation down.
“The numbers for Portugal are very clear: profit margins increased quite a bit in 2022,” he reportedly said.
“That is not sustainable, not only because that will have an impact on prices, but also on demand. So I think it will be a myopic perspective on the side of firms. This will increase the social pressure on wages to go up.”
Then in February, a member of the Executive Board of the European Central Bank (ECB), Fabio Panetta, said workers in Europe had borne the brunt of the surge in prices so far while, on balance, company mark-ups had “remained stable or even increased in some sectors.”
And last week, Reuters reported that ECB policymakers have recently discussed new data showing company profit margins have been increasing in Europe, not shrinking.
“It’s clear that profit expansion has played a larger role in the European inflation story in the last six months or so,” Paul Donovan, the chief economist at UBS Global Wealth Management, told the Reuters reporter who wrote the story.
“The ECB has failed to justify what it’s doing in the context of a more profit-focused inflation story.”
And in case you missed it, Mr Donovan also wrote an op-ed in the Financial Times in November where he declared that “today’s price inflation is more a product of profits than wages.”
“This unconventional inflation means higher unemployment and lower wages are not the only possible cure for it,” he wrote.
“Policy has more routes to lower inflation if the cause is about profits.”
New directions for monetary policy?
Of course, all of those economists and central bankers could be wrong about the profit dimension of today’s inflation.
Perhaps we’ll learn, in a few years, that no companies on the planet used the cover of this inflation to increase their margins a bit, and no companies exploited any temporary market power to hike prices and profits.
It will be interesting to see where the dust settles, once the numbers are in and some economists’ emotions have cooled down.
But that could be a while away.
And right now, central bankers are still trying to understand how they failed to see the surge in inflation coming in the first place, back in 2021.
And you can see them talking about their big forecast misses in the International Monetary Fund’s Finance and Development magazine.
The latest edition (for the March quarter) is dedicated to monetary policy and inflation.
Its contributors wonder if it’s time to rethink the foundation and framework of monetary policy, if fiscal and monetary authorities need to “break the rules” and start acting together, and why central bank policy committees need reform.
Here are some of the chapter headings, to give you a flavour of the discussion:
- How We Missed The Recent Inflation Surge
- Rethinking Monetary Policy in a Changing World
- Crisis and Monetary Policy
- Time for Change
You wouldn’t say the economists who contribute to the magazine are radical.
They’re IMF researchers and academics and former central bank governors who mostly see the world through orthodox frameworks.
But that’s what makes the magazine so interesting — it’s the elite-of-the-elite discussing the possible need for real change.
Why do they think they didn’t see this inflation coming?
How we missed the inflation surge
According to IMF researchers Christoffer Koch and Diaa Noureldin, four factors drove their big forecast misses.
First, they say when the pandemic shock first hit, governments provided massive fiscal stimulus to keep their economies afloat.
That stimulus helped economies to recover much faster than expected, which meant official predictions of dire output slumps didn’t eventuate.
“We find evidence that countries whose economic recovery from the pandemic shock was faster than expected — such as New Zealand, Singapore, and Türkiye — also experienced inflation that was higher than expected,” Koch and Noureldin say.
“This was more prevalent in 2021 than in 2022, hinting at a potential role for demand overstimulation in the initial phase of the recovery from the pandemic shock.”
Second, they say the unexpectedly-strong recovery in demand in most countries met highly constrained supply chains.
“Supply chain bottlenecks are normally caused by either demand or supply shocks, rarely a combination of the two,” they say.
“But during the initial COVID-19 lockdowns, a formidable combination of both forces was at play — demand for goods was increasing at a fast pace, while supply saw a temporary substantial retreat.
“We found that for countries in which demand played a more prominent role than supply in straining supply chains, forecast errors were larger on average,” they say.
Third, those demand-supply imbalances were amplified by the shift in demand from services to goods during the early lockdown period when the leisure and hospitality sectors basically stopped functioning.
This temporarily reversed a trend seen over the past couple of decades of goods inflation that was lower than services inflation.
“For economies where this reversal seemed sharp, with goods inflation more elevated than services inflation, forecast errors were larger as well,” they say.
“The shift in demand from services to goods was likely a driver of inflation misses in Brazil, Chile, and the US, where core goods inflation in 2021 was more than twice that of services.”
Fourth, unprecedented labour market tightness, which persists in some advanced economies (such as Australia), confounded some of the previous factors.
“Measured by the ratio of vacancies to unemployment, labour markets have been particularly tight in Australia, Canada, the UK, and the US, significantly correlating with the magnitude of these countries’ core inflation forecast errors,” they say.
What lessons can be learned?
To conclude, the IMF researchers say the combination of stronger-than-anticipated demand recovery, ramped-up demand clogging supply chains, sectoral shifts in demand, and a heated labour market offers a “convincing explanation” for why officials missed the surge in inflation in 2021 and 2022.
That process began well before Russia invaded Ukraine in early 2022.
They say the size of the fiscal stimulus announced by different governments in 2020 also correlates positively with inflation forecast errors in advanced economies in 2021.
However, they say that positive correlation is driven primarily by Australia, Canada, the UK, and the US — the same economies that experienced very tight labour markets in the pandemic.
And they think the inflation forecast errors are more attributable to misjudging the severity of supply constraints, including in labour markets, than to underestimating the impact of fiscal policy on the rebound in demand.
So, what lessons can they draw from their analysis?
They say inflation forecasts should better integrate the impact of fiscal policy, “particularly in an environment where supply constraints amplify the impact of excess demand on inflation.”
And they say policymakers could have been advised to “reduce their speed somewhat” back in 2020 “given the danger that was lurking down the road.”
“But this remains a partial assessment,” they warn.
“Only by comparing it with counterfactual scenarios of deep scarring can we really gauge the adequacy of the policy choices made back then.”
And note what their analysis doesn’t mention.
It says nothing about market power, or falling real wages and record profits, or the distributional conflict between businesses and workers.
Those things are real phenomena, which economists are now arguing about, but the IMF analysis is kept at a higher level than that.
Those questions will have to be settled later.