Re-live: Philip Lane on Inflation

Who would be on a committee to save the world from inflation and how would their toolkit look like? With this question, the moderator Torsten Riecke (Handelsblatt) kicked-off an extensive afternoon session at the XII. New Paradigm Workshop on one of the most pressing economic policy issues: how to deal with the price shock. The sudden rise in inflation after Covid and during the energy crisis has led to multiple unconventional attempts to stop the price spiral, including price caps, subsidising energy prices or comprehensive programs like the US Inflation Reduction Act. All this seem to contradict the long-held market-liberal paradigm of fighting inflation exclusively via central banks using the interest rate channel.

So, is there a case for replacing this paradigm, at least in cases of partially or mainly supply-side driven inflation? How could a new model of fighting inflation look like? Which should then be the role of central banks, governments and other actors (like social partners) in such a new paradigm?

We discussed this live and in color at our XII New Paradigm Workshop with Member of the Executive Board at the ECB, Philip Lane, Jérôme Creel (OFCE Paris), Isabella Weber (University of Massachusetts Amherst), Kerstin Bernoth (DIW Berlin), Ulrike Malmendier (UC Berkeley/German Council of Economic Experts), and Anatole Kaletsky (Gavekal Dragonomics).

Jérôme Creel started the session by his presentation on the question whether a new paradigm has emerged in taming inflation (this will also later this year become a New Economy Working Paper). In contrast to the standard textbook logic, expansionary fiscal policies partly had disinflationary effects. Crucial for the adaptation of fiscal policies are the distributional effects of monetary policy, as the poorest are not only hit hardest by inflation, but also by recessions induced by disinflation.

In the old paradigm, monetary policy should as the only game in town take care of price stability alone. Clearly, this has not worked very well, which raised the need for governments to step in. In Creel’s view, the Eurozone specific architecture of an incomplete monetary union constrains the ECB, facing a monetary-fiscal trade-off by the effect higher rates have on sovereign spreads. A second limit for monetary policy comes from the supply-sided nature of inflation, driven by the energy price shock and not primarily by excess demand. Finally, uncertainty on the slope of the Philips-curve translates into uncertainty on the cost of disinflation by higher rates, which made policy makers more cautious on using interest rates aggressively. Altogether, central banks seems to be limited in taming inflation, which opens up the government to step in. As fiscal policy is constrained by the strict rules of the European Stability and Growth Pact, this means we have to also talk about debt rules when talking about inflation, according to Creel.

In his keynote, Member of the Executive Board at the ECB Philip Lane laid out the ECB’s position on current inflation and how to best deal with it. He showed that despite higher rates consumption and investment are still upward trending. One of the reasons is the different origin of inflation in Europe (supply side and energy driven) than in the United States (more demand driven). He underlined that the ECB raised rates not because inflation in Europe was demand driven, but to keep expectations in line so that the price-wage-profit dynamics efficiently bring inflation back to target.

In her comments, Ulrike Malmendier (UC Berkely/German Council of Economic Experts) did not see any limits to the effectiveness of monetary policy and stretched that fiscal policy could only work with targeted interventions, while broader fiscal expansion would have adverse effects on inflation. Likewise, Kerstin Bernoth (DIW Berlin) argued that we do not need a new paradigm, but that all our instruments are already there on the table to be used. Fiscal-monetary coordination are most important, as monetary policy lacks the flexibility, which governments have in the light of energy price shocks. So, not so much change after all?

Isabella Weber (University of Massachusetts Amherst) disagreed by drawing attention to an alternative approach that can deal with sectoral price shocks without imposing large negative effects on the rest of the economy: expanding the toolbox, for example by price caps or coordination through institutions. Anatole Kaletsky also called for the need of a new paradigm in the fight against inflation, because both inflation and also disinflation have huge distributional effects, hitting the poor the hardest. According to Kaletsky, the old paradigm of central banks delivering price stability might only have worked best in an era of structural disinflation in the world economy, which seems to have come to an end.

Due to these structural factors, Kaletsky compared inflation to a relative safe explosive charge, which was then by the detonated by the energy shock, leading to explosive inflation. Thus, the old paradigm that inflation will move back to target as long as inflation expectations are anchored might not hold anymore. Pointing to policy errors in the pasts, Isabella Weber argued in the discussion that the old paradigm in the nature of fiscal restraint in the 2010s with underinvestment in green energy seems to be with us today like a hangover.

Not only but also because of past policy failures we now live in a world of overlapping emergencies. In a short session following the panel discussion, Isabella Weber presented her new work (which soon is going to be published as New Economy Working Paper) on when and how to use price controls. Her key message was that price caps are the ultima ratio to deal with supply chain shortfalls and should be implemented in high inflation risk sectors, which can be identified for example by input-output analysis.