Re-live: Philip Lane on Inflation

After the Price Shock – Time to Rewrite the Rules on How to Fight Inflation? We discussed this with Philip Lane at our XII New Paradigm Workshop.




9. MAY 2023



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.

No matter if inflation is coming from the supply side, there is still a dynamic. Once costs go up, there is a natural and essential need for wages to go up for some extent. But in turn, there has to be a wave of price increases to rebalance that. So, there is a dynamic there to respond to the initial shock. And the idea is: we want to set interest rate at such a level that this dynamic converges back to 2 percent sufficiently quickly, and it does not become locked-in and embedded in inflation expectations. This is why we have been raising rates. Not because the origin of inflation was the demand side, but to make sure this adjustment process returns to 2 percent quickly enough.
Philip Lane

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.

We had from the mid-1980s for 20-30 years a period when the whole world economy was experiencing disinflation, generated by globalisation, by technological changes, increasing competition with diminishing pricing power, and perhaps most importantly: huge political changes which changed the structural distribution of income between labor and capital income. Each one of them is now reversed.
Anatole Kaletsky

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.

Whether we are raising the interest rates now, is one part of the question. The second part is, whether in a world of zero interest rates there was not a lot of ambitious, mission oriented fiscal projects. We would have needed less quantitative easing, and more fiscal boldness. If we had the spirit of the IRA in the 2010s, we might have been more resilient regarding the energy shock.
Isabella Weber

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.

We need measures for disaster preparedness. In an ideal world this would not be price caps, but if you end up in an emergency shortage situation, then they may well be a tool of choice to buy time to address supply chain shortfalls.
Isabella Weber

Rewatch the Discussion



More than a decade after the financial crisis there still seems to be something seriously wrong with the financial system. Financial markets still tend to periodically misprice risk and contribute to boom and bust cycles. A better financial system needs to discourage short-termism and speculative activity, curtail systemic risk and distribute wealth more broadly.