January 16, 2022

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At what point does inflation really start to matter?

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When it comes to inflation, we’ve come to think of 2 per cent as the sweet spot. But would it really affect people’s and business’ economic decisions, should price pressures permanently creep a little higher?

We do not think that price rises of 3 per cent a year would lead to riots in the streets. But at what point on the spectrum of price pressures is economic officialdom playing with fire?

It’s the most important macro question there is right now. Inflation in the US has hit levels not seen in decades. At the same time, Fed watchers are struggling to get to grips with a new monetary framework under which the central bank has said they’ll allow inflation to drift above their 2 per cent goal for a time. It’s abundantly clear the Fed thinks the current inflationary spurt is transitory — and therefore tolerable. But, as far as we can tell, little is known about the rate at which the Fed would begin to fear the inflation monster — and for how long it would tolerate price rises of above 2 per cent.

Last Friday, macro investor and living example of nominative determinism Mark Dow told us that in the 1990s the received view was that the point at which inflation did begin to matter — by which we mean affect business’ investment decisions and people’s spending patterns — was seen as somewhere between 6 per cent and 8 per cent.

As with the 2 per cent target that most central banks have adopted, there’s no reason why 6 to 8 per cent ought to be some significant milestone for inflation. Even then, the suspicion was that it was different depending on which country you were stood in. Which makes it impossible to know whether, this time around, the tipping point will be the same as in the past.

After decades of consumer price inflation remaining pretty low, would we be more willing to tolerate higher inflation, the grimness of the 1970s and 1980s having subsided in most people’s minds? Or would it seem so out of sync with what we’ve become used to that even the slightest whiff of price pressures triggers panic? In the US, Google searches for inflation rose swiftly during the second quarter, but have since fallen back.

How has the swift rise in asset prices, particularly housing, relative to consumer prices since 2008 changed perceptions on what a socially acceptable level of inflation is?

It’s not just that there’s a lack of answers to these questions, it’s that they’re not being asked enough. And what that’s leading to is a somewhat binary debate about what could happen to inflation in the coming years. Hawks say we’ll end up with a return to the Volcker era, with farmers’ tractors circling the Fed as monetary policymakers raise rates dramatically to combat spiralling price rises. Doves point to official forecasts, which show price pressures peaking over the course of this year as economies reopen before drifting back towards 2 per cent.

We could end up with a world somewhere in between. Global supply chains and technological change may not have the deflationary impact that they have had since the 1970s. Post pandemic, the balance of power may have shifted slightly from capital towards labour, raising the likelihood of higher wage growth. Then there’s the phenomenon of greenflation. It’s feasible that, in such a world, the best target for inflation is a little higher than it is today.

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