Reviews | Deflation – not inflation – is the real concern

What worries me is that Fed officials are wrong and what is coming is not high inflation again, but worrying deflation. Here is an explanation of what could well happen:

If Year 1 prices are at 100, Year 2 prices will rise to 110, or 10% inflation. Year 3 prices remain at 110, or 0% inflation. But watch out when Year 4 prices fall to 105: that would still be 5% above Year 1 levels, but now we have 4.5% deflation. This is what happened in Japan, with back and forth between inflation and deflation.

The only reason inflation would pick up would be another shock. The Covid supply shock was waning, which made the Fed think inflation was temporary, but another shock – the war in Ukraine – boosted prices again. But now prices are falling and inflation is temporary, unless another Covid shock happens, for example. And unfortunately, central bankers have few ideas on how to solve deflation and the type of depressed economy that follows.

The longest timeline on the path of inflation that exists anywhere is instructive. The data is downloadable from the Bank of England in “FRED” and shows consumer price inflation for the UK since 1210. (US, for age reasons, cannot compete.) The chart shows that after bouts of high inflation, it is common to see years of falling prices. Deflation occurred in 340 of those years. High inflation is usually not followed by nearly as high inflation. Historically that doesn’t happen.

Oil prices have fallen, as have the prices of many commodities. An important signal of what is to come is the Baltic Dry Index, which crashed in June 2008 before the economic crisis of that year and is again in free fall. This is the daily price for the rental of giant ships called capesize, too large to pass through the Suez or Panama Canals. Prices are announced daily at 10 a.m. on the Baltic Exchange in London; wheat and coal are dry, oil is wet. The BDIY was 5600 in November and today it is 1100 and the cost of shipping containers has halved in 2022. None of this comes as a surprise given that the Chinese economy is slowing, with the rate of the lowest growth for 40 years and that the euro zone and the United Kingdom are already in recession. When global demand drops, ships stop sailing and prices drop. Deflation is fear.

So far, the job market has been quite resilient, but in the latest BLS jobs report, the unemployment rate rose from 3.5% to 3.7% and much higher for marginal workers who are the first to be affected by a weakening labor market; unemployment rates rose 0.4% for African Americans and 0.6% for Hispanics and high school graduates. Those who fare best in the boom fare worst in the doldrums: last in, first out, the worst is probably yet to come.

The United States entered a recession in December 2007, but even when Lehman Brothers collapsed in September 2008, the Federal Reserve and Chairman Ben Bernanke were caught by surprise. They all missed it together as the global economy went into freefall.

I saw with my own eyes how groupthink consumes central bankers when I was a member of the Bank of England’s interest rate setting committee from 2006 to 2009. I started voting for rate cuts in October 2007 for fear of the recession I saw coming and continued to do so for a year – all by myself. I was the only dissenter. The UK went into recession in April 2008 and the other members of my committee finally joined me in October 2008; soon we slashed rates like gangbusters and eventually pursued plenty of quantitative easing to support the economy. Those who missed the impending recession said no one should have expected them to see it coming (because they didn’t) and even if they did, it didn’t. would have made no difference. He would have.

The consensus today at the Fed is that rates in the United States need to be raised to avoid the possibility of a wage-price spiral as happened in the 1980s. But there is no way that this happens: real wages fall sharply. Then-Fed Chairman Paul Volcker stepped in and raised interest rates all the way to deal with “cost-driven” inflation. The relevance of this period is difficult to see. At the time, union membership around the world was considerably higher, having risen sharply in the 1970s. In the United States, powerful unions were able to negotiate cost-of-living adjustment (COLA) clauses in contracts, which meant that salary increases applied automatically if inflation exceeded a set amount. This world has disappeared into the ether. Unionization has collapsed globally and there is no chance of a wage-price spiral; no one has a COLA and wage growth remains weak. A price-wage spiral is now highly unlikely.

In these very uncertain times, it is surprising how central bankers at the Federal Reserve all read the same textbook. Certainly, they cannot all think exactly the same thing. And their approach does not inspire confidence given that they have already missed the biggest financial crisis in 80 years. There is no point in having a committee if everyone is just fooling around together. Groupthink is what makes organizations fail and they start over. Ordinary people will suffer the consequences.


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