A Breath of Fresh Air

Here are some pretty vanilla, frankly speaking quite boring and, we hope, universally agreeable statements about how monetary policymakers should view inflation, which sums up our thinking on the issue:

When it comes to inflation, granularity is key. You can't just look at the overall cost of living and call it a day. You have got to dig deep and pinpoint the specific drivers of price increases. Sure, food prices might be on the rise, but that's not the whole story. Maybe housing costs are skyrocketing because of a lack of supply. And that's where policy comes in - by identifying the root causes of inflation, policymakers can craft targeted responses that actually address the problem.

But it's not just about getting granular - you also need to take a sectoral perspective. Different parts of the economy can be feeling the heat in different ways. Raw materials prices might be driving inflation in manufacturing, while shifts in consumer preferences might be pushing up service sector costs. There are usually no standardized inputs that can be substituted easily and smoothly and sector-specific cogs-of-the-machine matter. One-size-fits-all policies won't cut it - policymakers need to tailor their responses to the unique inflationary pressures facing different sectors.

And let's not forget about interlinkages - the economy is a complex, interconnected system. A surge in energy prices might lead to higher costs for manufacturers, which in turn leads to higher prices for consumers. To truly understand inflation and address it effectively, policymakers must account for these ripple effects and anticipate the potential knock-on effects of policy decisions.

As we said in the beginning, we don’t think anyone would object to these statements, but if we dig deeper, it turns out a lot of people agree in principle but disagree in practice. And we understand why.

Somewhere along the way, we decided that monetary policy needs to be taken away from the hands of prying politicians who might instrumentalize it to win elections and not care about inflation and when faced with high inflation, they wouldn’t choose to follow policies that were needed to bring it down, fearing high unemployment. Don’t mind the illusion created by the word “we” there. “We” actually didn’t do it, some unelected technocrats did and these folks then persuaded politicians to enact laws and regulations that made this happen. Said politicians were apparently happy about this because they now had people to point to and blame if inflation was high so the interest rates had to be high (which, it turns out, is a hilariously misguided view and politicians still take the hit in their approval ratings during high inflation episodes, despite central bank independence, so central bankers pulled a fast one on politicians here) and reap the benefits of a buoyant economy when inflation and rates were low.

In a lot of countries, people had enough of the problems and equity issues created by governments micromanaging the economy, treating different sectors and firms differently and the inefficiencies that emerged as a result of soft budget constraints, so technocratic management that was removed from politics appealed to a lot of people. So, if you can leave aside the mind-boggling ontological contradiction in this picture, it was a win-win proposition.

[That contradiction: If a politician is able to pursue expansionary monetary policy and win elections, why should anyone object as it would implicitly mean the general public is OK with this? A somewhat sensible answer is that because people hyperbolically discount future consumption. Much less wonkishly put, folks want to consume things today and care less about the future, so that politicians are inclined to throw caution to the wind near election periods and create an “inflation bias”. So in the context of inflation, this might mean the allure of more consumption today can cause folks to disregard the possibility of a higher cost of living in the future, which is a “bad” thing, so monetary policy decisions should be made independently, the reasoning goes.

The problem is, people acting this way is not only an issue for monetary policy but literally everything. So why stop at the monetary policy? Another plausible answer is that the first and foremost responsibility of a decision-maker is to avoid ruin and irreversible catastrophes, bad monetary policy decisions can lead to hyperinflation, which is particularly sticky and ruinous so that’s why central bank independence makes sense in a democratic context. But if so, a lot of other things might lead to ruin, like excessive government spending, which can lead to debt defaults, or war, which can lead to… I guess you know what it can lead to. So let’s remove all crucial decisions from the hands of elected people while we’re at it.

Anyway, this article is not meant as a rant against central bank independence. Paraphrasing Kyla Scanlon, economics is based on vibes, and central bank independence apparently is a source of good vibes, but let’s not pretend that it should not be controversial. Let’s continue.]

So central banks, initially tasked with preventing money market crises and balance of payments management, were then given the responsibility of managing inflation, and in the 90s, gained independence. The problem was, people started to act as if it was only the central bank’s responsibility to ensure price stability while not endowing it with any other tools than it had before, and frankly, central bankers weren’t too unhappy about this either. In the next 30 or so years that followed, developed country central banks and the periphery ones that were forced by the IMF eventually, by and large, controlled monetary policy with a single lever: the policy interest rate. And things pretty much turned out just fine, apart from a couple of global and regional financial crises, and massive off-shoring of manufacturing capacity here and there. And while such crises forced central banks to innovate and find some new levers, like the Fed and its QE programs, which in part targeted the housing market specifically by buying MBS, the paradigm never fully changed and inflation (or deflation) continued to be treated as an aggregate phenomenon. Because the toolkit central banks had didn’t allow a differential and nuanced policy anyway.

One big sign of this treatment is that the entirety of the language around inflation targeting and monetary policy is based on aggregate concepts: Like the r-star, the supposed interest rate level that is neither expansionary nor contractionary, NAIRU, the supposed lowest unemployment rate that can be achieved without being inflationary, or the CPI itself. We find it pretty hard to believe that the basket of prices and the corresponding weights assigned to the elements of the said basket a central bank needs to track and target to ensure overall dynamic price stability is the exact same basket that includes goods and services that people consume today statically and the weights are in accordance with how much people spend on each item “today”.

Now here is a massive caveat: We find this paradigm non-sensical “right now”. HOWEVER, it does not mean it was not somewhat appropriate to think in aggregate terms back then. And by “back then”, we mean the entirety of human history. Because if one operates in a low information environment, which was probably ALWAYS the case in the context of macroeconomics, pretty much up until now, it is not entirely a bad idea to avoid a sectoral and granular view as the likelihood of unintended consequences was rather high, so it was quite probable that, say, a price control or other selective monetary measure applied in a specific sector to control inflation there could blow up other sectors and destabilize things overall.

Though this caveat in no way justifies believing in insane, preposterous things like inflation being always and everywhere a monetary phenomenon, we understand why people wanted to act and think as if monetary policy was a sanitary, scientific affair divorced from politics, conducted by technocrats and operated via a blunt instrument that is the policy interest rate that applied to everyone in the same way with no differentiation whatsoever, as we said in the beginning. (China is possibly the biggest standout here with its 387 policy rates, 878 local implementations, price controls, etc.)

Why do we find this paradigm non-sensical right now? Because a recent paper by and an Odd Lots appearance of one of our favorite active economists nowadays, Isabella Weber, reminded us that a different and better way of thinking about monetary policy is in the cards in the very near future. In the paper, Weber analyzes inflation in a way that is very old, that is in existence for roughly a hundred years in some shape or form: With Input-Output Tables, so that possible spillovers can be quantified if a specific sector in the economy receives an inflationary shock, and how the overall inflation will be affected can be analyzed. This way she is able to show which sectors have a more sizable impact on inflation than their weights in the CPI basket would indicate.

And Weber has a couple of excellent suggestions for improving inflation targeting and shock-proofing the entire system. A remarkable one is the minimum inventory requirements for firms operating in sectors with systemically important prices that are selected as a result of this analysis. We are all somewhat familiar with the discourse about systemically important financial institutions and the necessity of regulating them so that they don’t blow up the entire system if anything happens to them. But it was definitely not accepted wisdom until such a blow-up actually occurred. Until then, those financial institutions were adamant that they were operating just fine without tough regulations. Well, it turned out that they weren’t. Now we will have to go through the same motions for the non-financial sectors. The most successful ones were applauded for having extremely lean structures and just-in-time inventory management systems. But it was abundantly clear that just-in-time inventory management systems created huge fragilities in the entire global economy. All successful regulations thread a needle between the burden of regulation and some advantages provided to the regulated by the regulators. In the banking sector, this is done by regulating the banks but giving them and only them access to the lender of the last resort facilities by the central bank. In the non-financial sectors, a similar thing can be done by the central bank creating a limited lending facility to help the regulated sectors accumulate and maintain the required minimum inventory.

Weber’s study largely discusses the situation in the US economy, and the US is a monetary sovereign. However, the vast majority of the global economy is quite dissimilar to the US, and balance of payments issues and exchange rate movements explain a significant chunk of the inflationary pressures happening elsewhere. So, if we apply the same granular analyses in the RoW, we think it should be possible to unearth which sectors and firms to provide incentives to, and which products to localize to ensure price stability. Some of this is already done in various forms as part of industrial policies of successful developing countries, but we think the instrumentality of this in an inflation-targeting context is under-appreciated and there is more central banks can do in this regard without violating their singular mandate of ensuring price stability.

As we said, there is little entirely new here, but this way of thinking has been unfortunately pretty much forgotten in the monetary policymaking space, despite academic studies continuing in the meantime, for the reasons we talked about here. However, central banks’ ability to track payments, firms, and prices is immeasurably better than it was 20 years ago, let alone 100. And it will get much better in the future with the introduction of central bank digital currencies, which might endow money with memory. This, along with the global trend towards lower and lower cash use might mean central banks would be able to track prices and sectoral moves in real-time so that analyses like Weber’s can be done more precisely, and central banks can act more swiftly if they face adverse developments that could create larger turmoil down the road.

It would still be a good idea to be humble about what conclusions to draw from this set of analyses, as we still don’t have a good grasp of the actual pricing processes and heuristics firms employ and it seems likely that we will never fully do, but we think it would be a definite Pareto improvement to stop talking about things like r-star and NAIRU because they not only do not exist for the whole economy but for sectors. Heck, it’s not even remotely clear that they exist for individual firms at two different points in time. So for this, because she and her co-authors reminded us this alternative way of thinking about things, we think we owe Isabella Weber a debt of gratitude.