Inflationary pressures have returned to the global economy, and reserve banks the world over are reacting with the obligatory knee-jerk – raising interest rates. After all, tightening monetary policy always beats inflation … doesn’t it??
A review of the success of monetary policy as an inflation busting tool is therefore crucial, before central banks inadvertently reawaken stagflation.
A quick history lesson
In order to understand the drivers of inflation, we need to look at three separate periods:
Period 1 1960 to 1981 – characterised by exponentially increasing inflation
Period 2 1982 to 2010 – relatively stable inflation – orthodox opinion suggests emphatic commitment to monetary policy is what made the difference here!
Period 3 2011 to current – inflation is gradually returning, and orthodox economic theory can’t tell us why
Figure 1 Inflation and Fed Rates during Period 1 (1960 to 1981)
If we didn’t know the orthodox macroeconomic story and instead looked at the data, we could be forgiven for observing that Period 1 comprises a 20-year persistent trend of increasing inflation, which was impervious to the general trend of tightening monetary policy. The US Fed raised interest rates consistently from an effective rate just over 2% to around 12%, only to see inflation rise from 1.2% in 1962 to 13.5% in 1980. Period 1 shows an exponentially increasing driver of inflation, which was temporarily offset during periods of tightening monetary policy, but which nonetheless persisted throughout.
Believers in Volcker’s dominion over the inflation dragon claim that a step-change in monetary policy in 1980 triggered a turning point in 1982, convincing markets thereafter that the Fed meant business on inflation. There are two problems with this theory – 1) the Volcker maximum was not particularly outstanding when considered in the context of previous tightening cycles. It was larger, but not dis‑proportionately so, and 2) it fails to explain the prior period of exponentially increasing inflation.
We’re left wanting a convincing explanation for monetary policy’s sudden efficacy after the early 1980’s, following the previous 20 years of it being only useful to temporarily suppress demand.
Certainly, during Period 2, monetary policy has been used repeatedly and successfully to address inflation. It’s very clear that as business confidence has waxed and waned over this period, prompt policy action has provided countercyclical corrections, controlling inflation (Figure 2).
Figure 2 Inflation and Fed Rates during Period 2 (1982 to 2010)
However, it is just as clear that during Period 1 monetary policy was not effective – as soon as it was loosened, inflation bounced back to the underlying exponentially increasing trend. By contrast, during Period 2 there was no such ‘bounce back’.
Clearly, we need a more comprehensive understanding of the causes of inflation before we impose higher interest rates on the world again.
Causes of inflation
If we are to fully understand whether monetary policy will be effective as an inflation busting tool, we must first recognise that inflation has several causes. And the effectiveness of monetary policy varies, depending on the salient cause.
Broadly, tighter monetary policy takes ‘heat’ out of the economy by taking disposable income out of the hands of consumers, and by changing expectations about future consumer spending. It’s therefore effective as a counter-cyclical intervention.
However, hyped-up consumer and business confidence is not the only cause of inflation. There are a range of macroeconomic maladies for which inflation is the visible symptom, and we must be careful to focus on the underlying disease, not merely the symptom.
Another relevant cause of inflation is supply-chain disruption. The case for using monetary policy in this situation is much weaker, but some argue that inflation left unaddressed may create the conditions for a vicious spiral of wages and prices. When supply chain disruption is the cause of inflation, raising rates does nothing whatsoever to address the underlying cause. Raising rates at the start of 2023 will not return Ukraine to productivity, re-open factories closed by Covid, nor enable local suppliers to substitute previously imported goods. Increasing interest rates reduces supply problems by temporarily shrinking the real economy to the point where demand matches the temporarily suppressed supply capacity.
Its saving grace is that it is reversable – when temporary constraints on supply are removed, monetary policy can be loosened and the economy should broadly return to its previous state. Tighter monetary policy suppresses demand temporarily, but (apart from its ability to impact fickle human expectations) monetary policy does relatively little to change the underlying structure of supply and demand in the economy.
However, now I want to point to another (under-appreciated) macroeconomic disease that can also masquerade as hyped business confidence because inflation is its visible symptom.
This third cause of inflation is particularly dangerous for a cool-handed monetarist hell-bent on using their one policy hammer to strike at everything that resembles a nail, because tightening monetary policy to ‘cure’ this form of inflation is not merely unhelpful, it is self-defeating. It will suppress demand while also exacerbating the underlying cause of inflation, and result in a see-saw effect of booms and busts underwritten by exponentially increasing inflation, suppressed demand and unemployment. In short, using monetary policy to address this form of inflation causes Stagflation.
This third cause to which I am referring is a discontinuity in capital markets.
Undergrad econ students learn that inflation is caused by excessive demand for stuff compared to the ability to produce that stuff. However, it is under-appreciated that the imbalance in ‘stuff’ able to cause inflation is not limited to consumption stuff. Imbalance in ability to generate a stock of investment capital can also cause inflation, as can an imbalance in the ability of the economy to generate consumer demand. Inflation therefore occurs when the ratio of aggregate capital to aggregate income (the ‘capital ratio’) reaches, respectively, either a nadir or zenith.
Stagflation and the Capital Ratio Nadir
When the capital ratio reaches its nadir (such as in the late 1960s to mid-1970s), the salient macroeconomic malady is an inability to generate sufficient financial capital. The resulting capital‑starvation of firms suppresses supply.
In the dying days of the hegemony of Keynesian economics, tax scales were highly progressive (see Figure 3, where Top Marginal Tax rate is provided as a proxy for tax progressivity). This constrained the ability of capitalists to build the stock of capital need. Super-profits went to the government, instead of being saved to invest in future growth. Supply capacity therefore lagged demand, causing inflation, and a spiralling cost of capital.
It is that capital starvation that was responsible for the inflation during Period 1 which was impervious to monetary policy.
Monetary policy during that period was self-defeating – increased interest rates temporarily killed consumer demand, but also increased business operating costs, thereby reducing profitability and reducing still further the capacity to generate capital needed for growth. Tightening monetary policy therefore exacerbated the underlying cause of inflation, while also causing a temporary contraction.
This explains why, in the 1960 and 1970s, as monetary policy was repeatedly tightened, this did nothing to arrest the trend increase in inflation, but resulted instead in a see see-saw between two conditions (refer Figure 1):
- Briefly suppressed demand while monetary policy was tightened
- Bounce-back to high inflation as soon as monetary policy was loosened
That describes “Stagflation”, and tightening monetary policy was part of the cause.
Figure 3 Capital Ratio and Top Marginal Tax Rate – (1913 to end of Period 1)
The reason inflation was tamed in Period 2 is not because Volcker’s rate hikes were more emphatic. Inflation was finally tamed in Period 2 because other policy settings were changed, which addressed the underlying cause of inflationary pressure. These were the set of policies characterised as the supply-side revolution – the beginning of the hegemonic era of Neo‑Classical economics.
This impacted progressivity of taxation (Figure 4), as well as a range of other policy settings such as fiscal policy, privatisation and government procurement. In essence, governments reduced their role in the economy, and focussed policy settings on assisting firms to address supply challenges, including assisting firms to generate and store financial capital needed to fund future growth.
This basket of policy changes resulted in a dramatic shift in the path of the Capital Ratio, which had been steadily declining for several decades (Figure 3), but which plateaued from 1972 following the tax reductions in the early 1960’s. Capital ratio then began rising following the dramatic reduction in top marginal tax rates at the start of Period 2.
These words are sacrilege to most central bankers, who fervently believe that Volcker’s perseverance in offering libations to the gods of monetarism were eventually rewarded in 1982 after 20 years of capricious silence from that celestial realm. But a belief that yet more tightening of monetary policy in 1980 worked, after similar policy interventions had been consistently ineffective for the preceding 20 years is an act of faith over evidence. And it ignores the question of the causal mechanism of inflation.
Figure 4 Capital Ratio and Top Marginal Tax Rate (Period 1 and Period 2)
The Halcyon Period of Stable Inflation
From 1980 to 2010 the utility of monetary policy in counteracting the effect of business cycles has lulled monetarists into a false sense of security. But the effectiveness of monetary policy during this period has depended on the capital ratio being at neither a nadir nor at a zenith.
During this period the range of causes of inflation have been limited to only those for which monetary policy is effective – either hyped consumer and business confidence or supply disruptions. The problematic third cause of inflation – the capital market discontinuity – has been absent because global capital markets have been able to absorb changes in capital ratio through adjustment of rate of return on capital.
Any undergrad economics student of Neo-Classical economics is familiar with the axiomatic relationship between return on capital and economic output:
During this stable period, the stock of global capital expressed as the ratio of capital to income ( ) increased steadily in line with increasing wealth inequality. Meanwhile, the capital share of the economy (
) remained relatively stable. As a result, the average rate of return on capital (
) has declined steadily and linearly (Figure 5).
Figure 5 Capital Ratio and Yield on Treasury Bonds (Period 2)
The Capital Ratio Zenith, and the return of untameable inflation
Unfortunately, this easy period for central bankers has now come to an end, and we must again contend with inflation that is resistant to (and exacerbated by) monetary policy.
Around 2011 the linear decline in rate of return could no longer absorb the increasing global savings glut created through the 30-year hegemony of supply-side macroeconomic policy. The steadily declining return on capital eventually reached a tipping point because forecast returns to investors turned negative. (Projected returns must include a risk margin of a couple of percentage points, so a realised rate under 2.0 percent translates into a negative risk-adjusted forecast rate.)
When capital ratio reached a sufficiently high level, investors demanded higher nominal risk‑adjusted returns to ensure that actual returns remained positive.
To be clear, until that risk-adjusted zero lower bound return was reached, capital market equilibrium simply distributed returns more thinly amongst the owners of capital, resulting in a decline in rate of return. However, once that risk-adjusted zero lower bound was reached in 2010/11, there were only two possibilities:
- The capital share of aggregate income be decreased such that the stock of capital was no longer increasing faster than the size of the economy. This would have required significant policy intervention.
- The trend decline in return on capital be stabilised or reversed by a discontinuity in capital markets, sufficient to offset any further excess of capital‑created over income growth.
In practice, Option 1 can only be achieved through significant public policy action to direct a greater share of aggregate income to rewarding labour rather than capital. In the absence of such government intervention, capital markets will inevitability drive toward Option 2. We have seen this in the form of increased share buy-backs, and increases in corporate profit margins driving “cost push inflation”. Here, the line item within each corporations’ cost structure subject to cost pressure is the profit demanded by shareholders. Corporate profits have been forced to increase (in nominal terms) by capital owners, because the ballooning stock of savings must generate its return from a proportionately smaller source of income.
We don’t need to rely merely on anecdotes to evidence this fact – it is clearly apparent in the empirical data, which shows return on capital flat-lining despite a significant uptick in capital ratio since 2011 (Figure 6). Rates of return on capital are not asymptotically approaching zero as the capital ratio increases – instead, the market return on capital has hit a floor between 1% and 2%.
Figure 6 Capital Ratio and Yield on Treasury Bonds (Periods 2 and 3)
The axiomatic relationship that defines rate of return in an open capital market ensures that, having reached that zero lower bound return, any further increase in capital ratio has only one place to go:
If capital ratio () is increasing, but return on capital (
) has reached its minimum, then in the absence of policy intervention, investment markets will demand an increase in the capital share of economic output (
). Thus, increasing savings glut demands increasing corporate profits which (given ‘sticky’ wages) drives ‘cost-push’ inflation.
Anecdotes of ‘price gouging’ should therefore not be seen as aberrant behaviour of corporations, soon to be corrected through competitive market forces. Rather, this now reflects the new normal.
But that’s not the end of story. The astute observer will note that an increase in capital share () will, all things being equal, lead to a further increase in capital ratio (
), as the larger share of income going to capital will disproportionately land in the hands of wealthy capital owners whose marginal propensity to spend is lower than the societal mean. As a result, this ‘new normal’ will drive a persistent disequilibrium in capital markets, which will feed a run-away process of accelerating wealth inequality, increasing capital ratio, and still further demand for increasing capital share of aggregate income.
Cost-push inflation will continue and will increase in the absence of government intervention. We should expect the return of exponentially increasing inflation that is impervious to monetary policy.
Monetary policy will now cause stagflation
Monetary policy action does not deter capital owners from demanding a non-zero return on capital. And capital owners have both the financial sophistication and administrative authority within corporations to adjust pricing and profit markups in response to macroeconomic fluctuations. Increasing business costs caused by increasing cost of debt will therefore provide yet another component of cost-push inflation. Tightening monetary policy will increase business costs, which will increase underlying inflation, within the context of suppressed consumer demand. This tension will drive the same see-saw response to monetary policy seen in Period 1.
Increasing interest rates will therefore reduce aggregate demand without impacting capital ratio, nor the capital share of the economy. Tightening monetary policy will shrink the size of the economy but won’t impact the cause of inflationary pressure. As a result, we will see firm responding by laying-off staff in order to ensure continuing profitability – capital will continue to claim its share of whatever level of economic activity remains after interest rate hikes have taken effect. If pursued in earnest, this will result in suppressed demand, but with an inflation bounce-back when monetary policy is loosened – a return to stagflation.
A counterintuitive policy prescription is required
Hitting the zero lower bound of return on capital has triggered a state-change – from this point forward, increasing aggregate savings will no longer reduce return on capital, but instead will cause cost-push inflation and increasing capital share. Just as in the Stagflation epoch of the 1970’s, monetary policy will have the ability to temporarily kill demand, but will do nothing to address the underlying structural issue driving inflation – the capital market disequilibrium.
Addressing this form of inflation demands (counterintuitively) increased fiscal action (within supply capacity constraints, of course). Just as the solution to stagflation in the 1970’s (the capital ratio nadir) was an embrace of supply-side economics, now (at the capital ratio zenith) re-balancing the economy and defeating inflation will require a global return to demand-side, Keynesian policies together with significantly increasing the progressivity of taxation to address the savings glut.
But it’s no straightforward matter – the policy challenge in 2023 must consider all three causes of inflation and recognise that each demands a diametrically opposed policy intervention.
Hyped consumer and business confidence, and to a lesser extent supply-chain disruptions, still justify tightening monetary policy.
However, Central banks must urgently quantify the extent to which inflation is currently driven by investors’ demands for increasing nominal profits. In the absence of fiscal and taxation policy changes, this inflationary driver will increase exponentially, and monetary policy action will be worse than useless to address it.