Inflation and pandemic recoveries in five major economies

My discussion
about current inflation two weeks ago focused on the UK. Over a year
ago I wrote
a post called “Inflation and a potential recession
in 4 major economies”, looking at the US, UK, France and Germany. I
thought it was time to update that post for countries other than the
UK, with the UK included for comparison and with Italy added for
reasons that will become clear. I also want to discuss in general
terms how central banks should deal with the problem of knowing when
to stop raising interest rates, now that the Fed has paused its
increases, at least for now.

How to set
interest rates to control inflation

This section will be
familiar to many and can be skipped.

If there were no
lags between raising interest rates and their impact on inflation
then inflation control would be just like driving a car, with two
important exceptions. Changing interest rates is like changing the
position of your foot on the accelerator (gas pedal), except that if
the car’s speed is inflation then easing your foot off the pedal is
like raising rates. So far so easy.

Exception number one
is that, unlike nearly all drivers who have plenty of experience
driving their car, the central banker is more like a novice who has
only driven a car once or twice before. With inflation control, the
lessons from the past are few and far between and are always
approximate, and you cannot be sure the present is the same as the
past. Exception number two is that the speedometer is faulty, and
erratically wobbles around the correct speed. Inflation is always
being hit by temporary factors, so it’s very difficult to know what
the underlying trend is.

If driving was like
this, the novice driver with a dodgy speedometer should drive very
cautiously, and that is what central bankers do. Rapid and large
increases in interest rates in response to increases in inflation
might slow the economy uncomfortably quickly, and may turn out to be
an inappropriate reaction to an erratic blip in inflation. So
interest rate setters prefer to take things slowly by raising
interest rates gradually. In this world with no lags our cautious
central banker would steadily raise interest rates until inflation
stopped increasing for a few quarters. Inflation would still be too
high, so they might raise interest rates once or twice again to get
inflation falling, and as it neared its target cut rates to get back
to the interest rate that kept inflation steady. [1]

Lags make the whole
exercise far more difficult. Imagine driving a car, where it took
several minutes before moving your foot on the accelerator had a
noticeable impact on the car’s speed. Furthermore when you did
notice an impact, you had little idea whether that was the full
impact or there was more to come from what you did several minutes
ago. This is the problem faced by those who set interest rates. Not
so easy.

With lags, together
with little experience and erratic movements in inflation, just
looking at inflation would be foolish. As interest rates largely
influence inflation by influencing demand, an interest rate setter
would want to look at what was happening to demand (for goods and
labour). In addition, they would search for evidence that allowed
them to distinguish between underlying and erratic movements in
inflation, by looking at things like wage growth, commodity prices,
mark-ups etc.

Understanding
current inflation

There are
essentially two stories you can tell about recent and current
inflation in these countries, as Martin
Sandbu notes. Both stories start with the commodity
price inflation induced by both the pandemic recovery and, for Europe
in particular, the war in Ukraine. In addition the recovery from the
pandemic led to various supply shortages.

The first story
notes that it was always wishful thinking that this initial burst of
inflation would have no second round consequences. Most obviously,
high energy prices would raise costs for most firms, and it would
take time for this to feed through to prices. In addition nominal
wages were bound to rise to some extent in an attempt to reduce the
implied fall in real wages, and many firms were bound to take the
opportunity presented by high inflation to raise their profit margins
(copy cat inflation). But just as the commodity price inflation was
temporary, so will be these second round effects. When headline
inflation falls as commodity prices stabilise or fall, so will wage
inflation and copy cat inflation. In this story, interest rate
setters need to be patient.

The second story is
rather different. For various (still uncertain) reasons, the
pandemic recovery has created excess demand in the labour market, and
perhaps also in the goods market. It is this, rather than or as well
as higher energy and food prices, that is causing wage inflation and
perhaps also higher profit margins. In this story underlying
inflation will not come down as commodity prices stabilise or fall,
but may go on increasing. Here interest rate setters need to keep
raising rates until they are sure they have done enough to eliminate
excess demand, and perhaps also to create a degree of excess supply
to get inflation back down to target.

Of course reality
could involve a combination of both stories. In last year’s post I
put this collection of countries into two groups. The US and UK
seemed to fit both the first and second story. The labour market was tight in the US because of a strong
pandemic recovery helped by fiscal expansion, and in the UK because
of a contraction in labour supply partly due to Brexit. In France and
Germany the first story alone seemed more likely, because the pandemic
recovery seemed fairly weak in terms of output (see below). 

Evidence

In my post two weeks
ago I included a chart of actual inflation in these five countries.
Here is a measure of core inflation from the OECD that excludes all
energy and food, but does not exclude the impact of (say) higher
energy prices on other parts of the index because energy is an
important cost.

Core inflation is
clearly falling in the US (green), and rising in the UK (red). In
Germany (light blue) core inflation having risen seems to have
stabilised, and the same may be true in France and Italy very
recently. The same measure for the EU as a whole (not shown) also
seems to have stabilised.

If there were no
lags (see above) this might suggest that in the US there is no need
to raise interest rates further (as inflation is falling), in the UK
interest rates do need to rise (as they did last month), while in the
Eurozone there might be a case for modest further tightening.
However, once you allow for lags, then the impact of the increases in
rates already seen has yet to come through, so the case for keeping
US rates stable is stronger, the case for raising UK rates less clear
(the latest MPC vote was split, with 2 out of 7 wanting to keep rates
unchanged) , and the case for raising rates in the EZ significantly
weaker. (The case against raising US rates increases further because
of the
contribution of housing, and falling wage inflation.)

As we noted at the
start, because of lags and temporary shocks to inflation it is
important to look at other evidence. A standard measure of excess
demand for the goods market is the output gap. According to the IMF,
their estimate for the output gap in 2023 is about 1% for the US
(positive implies excess demand, negative insufficient demand), zero
for Italy, -0.5% for the UK (and the EU area as a whole), and -1% for
Germany and France. In practice this output gap measure just tells
you what has been happening to output relative to some measure of
trend. Output compared to pre-pandemic levels is strong in the US,
has been pretty strong in Italy, has been quite weak in France, even
weaker in Germany and terrible in the UK (see below for more on
this).

I must admit that a
year ago this convinced me that interest rate increases were not
required in the Eurozone. However if we look at the labour market
today things are rather different. Ignoring the pandemic period,
unemployment has been falling steadily since 2015 in both Italy and
France, and for the Euro area as a whole it is lower than at any time
since 2000. In Germany, the US and UK unemployment seems to have
stabilised at historically low levels. This doesn’t suggest
insufficient demand in the labour market in the EZ. Unemployment data
is far from an ideal measure of excess demand in the labour market,
so the chart below plots another: employment divided by population,
taken from the latest IMF WEO (with 23/24 as forecasts).

Once again there is
no suggestion of insufficient demand in any of these five countries.
(The UK is the one exception, until you note how much the NHS crisis
and Brexit have reduced the numbers available for work since the
pandemic.)

This and other
labour market data suggests our second inflation story outlined in
the previous section may not just be true for the US and UK, but may
apply more generally. It is why there is so much focus on wage
inflation in trying to understand where inflation may be heading. Of
course a tight labour market does not necessarily imply interest
rates need to rise further. For example in the US both wage and price
inflation seem to be falling despite a reasonably strong labour
market, as our first inflation story suggested they might. The
Eurozone is six months to a year behind the US in the behaviour of
both price and wage inflation, but of course interest rates in the EZ
have not risen by as much as they have in the US.

Good, bad and
ugly pandemic recoveries

The chart below
looks at GDP per capita in these five countries, using the latest IMF
WEO for estimates for 2023.

Initially I will
focus on the recovery since the pandemic, so I have normalised all
series to 100 in that year. The US has had a good recovery, with GDP
per capita in 2023 expected to be five percent above pre-pandemic
levels. So too has Italy, which is forecast to do almost as well.
This is particularly good news given that pre-pandemic levels of GDP
per capita were below levels achieved 12 years earlier in Italy.

Germany and France
have had poor recoveries, with GDP per capita in 2023 expected to be
similar to 2019 levels. The UK is the ugly one of this group, with
GDP per capita still well below pre-pandemic levels, something I
noted in my post two weeks ago. Unlike a year ago, there is no reason
to think these differences are largely caused by excess demand or
supply, so it is the right time to raise the question of why there
has been such a sharp difference in the extent of bounce back from
Covid. To put the same point another way, why has technical progress
apparently stopped in Germany, France and the UK since 2019.

Part of the answer
may be that this reflects long standing differences between the US
and Europe. Here is a table illustrating this.

Growth in GDP per
capita in the US has been significantly above that in Germany, France
or Italy since 1980. At least part of that is because Europeans have
chosen to take more of the proceeds of growth in
leisure. However this difference is nothing like the gap in growth
that has opened up since 2019. (I make no apology in repeating that
growth in the UK, unlike France or Germany, kept pace with the US
until 2007, but something must have happened after that date to
reverse that.)

I have no idea why
growth in the US since 2019 has been so much stronger than France or
Germany, but only a list of questions. Is the absence of a European
type furlough scheme in the US significant? Italy suggests otherwise,
but Italy may simply have been recovering from a terrible previous
decade. Does the large
increase in self-employment that occurred during the
pandemic in the US have any relevance? [1] Or are these differences
nothing to do with Covid, and instead do they just reflect the larger
impact in Europe of higher energy prices and potential shortages due
to the Ukraine war. If so, will falling energy prices reverse these
differences?

[1] If wage and
price setting was based on rational expectations the dynamics would
be rather different.

[2] Before
anti-lockdown nutters get too excited, the IMF expect GDP per capita
in Sweden to be similar in 2023 to 2019.