Post-Covid economy needs intellectual re-evaluation

Synopsis: Central banks across the world are facing a great challenge to control inflation

Introduction

The global financial crisis and the current pandemic are likely to reorient our thinking on conventional macroeconomics. For example, there are now serious doubts on the long-standing wisdom that the economy functions best with an “invisible hand” and with minimum government “intervention”.

Perhaps the greatest challenge is currently being faced by central banks across the world as they are struggle to bring inflation down. Annual inflation is running at 5.2% in the US, 3.2% in the UK and 3.3% in the EU.

Why it is expected that elevated inflation will sustain for more time?

In the last decade, due to very minimal investments in commodities exploration due to ESG (Environmental, social, and governance) constraints, supply chains are significantly unprepared to meet the current demand.

With respect to semiconductor shortage, there are no closed plants to reopen.

These supply side issues are largely structural in nature (meaning they’ll take time to go away), hence it’s correct to assume elevated inflation expectations will likely fuel a global inflation cycle.

On the same lines, independent research by the Federal Reserve Bank of St Louis has concluded that higher inflation in the US is a broader, not a transient phenomenon.

Why Central banks are struggling to bring down inflation?

There is now a perceptible difference in what is driving inflation. It is neither wage increases nor fiscal expansion. It is global supply shocks.

Two problems confront the central banks

One, they cannot raise interest rates because they have got everyone addicted to low or no rates.

Two, inflation caused by supply disruption is not responsive to monetary treatment.

So, how can we explain the current inflation upswing?

One of the important tools for understanding inflation behaviour through standard economics textbooks is the Phillips curve. It presumes that inflation is partly driven by gap variables measuring how much economic activity deviates from its potential.

Gap variables can include the per cent deviation of real GDP from potential GDP, also known as the output gap/domestic slack.

Any central bank monetary policy statement, including that of the RBI, always identifies the gap variable as a significant determinant of inflation.

In the modern version of the Phillips curve, inflation depends not only on gap variables but also on expected inflation. However, recent research indicates that with improved anchoring, the expected inflation term in the Phillips curve becomes more stable.

Consequently, movements in the level of inflation are driven less by expected inflation and more by the output gap. Herein lies the missing link, with reference to India.

Based on research, in India the link between inflation change and output gap was never strong . Interestingly, the link is completely lost with the emergence of Covid-19.

Thus, the concept of output gap is grossly inadequate to explain the inflation behaviour in India.

If the output gap is not the cause, then what are the factors responsible for inflation?

It is possible to hypothesise that inflation in India reflects an economy that is supply-constrained with productivity of enterprises held back by a license-compliance-inspection (LIC) system.

Source: This post is based on the article “post-Covid economy needs intellectual re-evaluation” published in Indian Express 23rd Oct 2021.