5 questions for Charles Goodhart and Manoj Pradhan on global inflation and demographic reversal
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China’s disinflationary impact put the Phillips Curve into a coma. Demographic shifts & declining globalization are reversing this trend, reviving the Phillips Curve & leading to higher inflation.
Goodhart/Pradhan on what created the low inflationary environment that has set our expectations, “…Goodhart: People generally assume that the low, steady inflation that started in the 1990s is due to better monetary policy and the central bank’s ability to keep inflation down. We disagree. Pradhan: Central banks have picked up so much credibility because there’s debate that the Phillips Curve is dead and, as a result, central banks only have to worry about growth, as opposed to inflation. It makes their job relatively easy: If growth goes down, you cut rates. And if growth looks like it’s overheating, you raise rates to slow things down. But we argue that it’s China that put the Phillips Curve in a coma — and that the pandemic and demography are going to revive it.China was a massive disinflationary force because it allowed the US and other advanced economies to focus on consumption which, while keeping average global composition of growth pretty sound, really only resulted in investment in China. Also, the West was able to harness China’s technology revolution and well-trained and low-cost workforce. This all worked against what you would see in the Phillips Curve. Goodhart:At the same time, there was a huge influx of female workers and Baby Boomers into the workforce, which shocked the sector and led to weak bargaining power and lower inflation on wages and prices.Pradhan: Unfortunately, the central bank’s models didn’t catch these strong inflationary forces lurking in the background and instead attributed low inflation to their inflation-targeting regimes….”
James Pethokoukis, "5 questions for Charles Goodhart and Manoj Pradhan on global inflation and demographic reversal," American Enterprise Institute, April 17, 2021, https://www.aei.org/economics/5-questions-for-charles-goodhart-and-manoj-pradhan-on-global-inflation-and-demographic-reversal/5 questions for Charles Goodhart and Manoj Pradhan on global inflation and demographic reversal
Why have America’s inflation rates been so low for decades? How do long-term demographic forces affect inflation? And would higher inflation really be a bad thing for Americans? Recently, I explored these questions and more with Charles Goodhart and Manoj Pradhan.
Below is an abbreviated transcript of our conversation. You can read our full discussion here. You can also subscribe to my podcast on Apple Podcasts or Stitcher, or download the podcast on Ricochet.
Charles is a financial markets professor emeritus at the London School of Economics, and a former member of the Bank of England’s Monetary Policy Committee. Manoj is the founder and chief economist of the independent macroeconomic research firm Talking Heads Macro. They are the co-authors of The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, released last August.
What is the current economic consensus on inflation? Why have we had low inflation over the past few decades?
Goodhart: People generally assume that the low, steady inflation that started in the 1990s is due to better monetary policy and the central bank’s ability to keep inflation down. We disagree.
Pradhan: Central banks have picked up so much credibility because there’s debate that the Phillips Curve is dead and, as a result, central banks only have to worry about growth, as opposed to inflation. It makes their job relatively easy: If growth goes down, you cut rates. And if growth looks like it’s overheating, you raise rates to slow things down. But we argue that it’s China that put the Phillips Curve in a coma — and that the pandemic and demography are going to revive it.
China was a massive disinflationary force because it allowed the US and other advanced economies to focus on consumption which, while keeping average global composition of growth pretty sound, really only resulted in investment in China. Also, the West was able to harness China’s technology revolution and well-trained and low-cost workforce. This all worked against what you would see in the Phillips Curve.
Goodhart: At the same time, there was a huge influx of female workers and Baby Boomers into the workforce, which shocked the sector and led to weak bargaining power and lower inflation on wages and prices.
Pradhan: Unfortunately, the central bank’s models didn’t catch these strong inflationary forces lurking in the background and instead attributed low inflation to their inflation-targeting regimes.
But your book argues that this dynamic is reversing, resulting in higher inflation. Tell me about this reversal.
Goodhart: First off, demography has clearly reversed in regards to ratio dependence, particularly with the old. The surge in the proportion of those who are actually working in the population is going to reverse, and the old actually consume more than those who are working age, as they consume a lot of public goods.
Beyond that, there’s a decline in globalization, for obvious political reasons. This will reverse the 40-year decline of bargaining power for labor in the West. These underlying trends — combined with the policy responses to COVID — are going to cause higher inflation much earlier than central bankers now predict.
Pradhan: If you look today, monetary aggregates are at very high levels. And the decline in velocity that has been holding monetary aggregates back will normalize as we hopefully start living more normal lives. And at the same time, that massive pool of personal savings that we’ve seen accruing will start to be spent, causing the output gap to close very quickly. By the end of 2022, it’s likely you’ll see monetary aggregates and the Phillips Curve pointing in the same direction towards higher inflation.
Is this good news? Inflation can sometimes be beneficial, right?
Pradhan: It depends. If you’re looking at the parts of the labor force that have not able to keep up with purchasing power, it wouldn’t be bad because you’re talking about a reduction of within-country inequality, which is good news. Inflation will also bring a small increase in productivity, a lowering of the real burden of debt, and many other benign developments. So initially, the broad effects of inflation will be welcomed as a huge success by nearly everyone.
But once it starts getting into things like financial markets or people’s earnings quality, inflation has significant attritional effects that make it very difficult. So while governments will welcome inflation because they’re the ones issuing debt, the central banks won’t like it. If they start to fight inflation, I fear that the ill effects from the slowdown they will try to induce will be very hard. So basically, this will be an attritional story that gets uglier over time.
Why aren’t other macroeconomists talking about this? As we mentioned earlier, the consensus seems to be that these are problems not worth really giving much attention to.
Goodhart: For one, our story is global, whereas people tend to think only in terms of their own nation-state. So the effect of China, which inflated the world, has been ignored. Moreover, all the Phillips Curve stuff concentrates on the level of employment and unemployment relative to inflation in one country. But given globalization, you cannot really do that.
Economists have also tended to focus on the short-term rather than the medium- and longer-term, which means they can easily ignore demography, as it is very slow-moving. It started to change in 2010, but it’s only beginning to pick up steam right now, especially as a lot of working forces are declining and the need for people in service economies is increasing. That’s effectively going to force wages up as people chase for labor.
If your theory is right, should I be concerned about the amount of debt that the US government is taking on?
Goodhart: Concerned, but not despondent. Public spending on an aging society means a much higher level of taxation will have to be imposed on an increasingly small working group. The problem is that taxes are always extremely politically unpopular. So because of the unpopularity of taxation, we ultimately think inflation will rise. Politicians just will not raise tax rates sufficiently to bring what is currently a very large primary deficit back into balance.
Pradhan: Clearly, reducing the debt burden has to be faced through inflation, partly through central banks permanently holding a significant amount of the government debt on their balance sheets. But the central banks are greatly overestimating their ability to reduce their balance sheets to what they were before the Great Financial Crisis. In fact, they will have to become part and parcel of absorbing, and perhaps increasing, a steady supply of government bonds by turning them effectively into consols so that the government can issue and reissue them for the central bank to keep absorbing. Without that, I think the challenges that Charles has laid out will become a lot harder.
Ed Comment:"I don't know if we get inflation. Like everyone, I'm overly anchored by my historical expectations. But I believe China held down prices in underestimated ways, that globalization has largely run it course, as we gave offshore much of what was economically logical to offshore, and that demographics will gradually raise consumption faster than output as baby-boomers retire and "consume" their savings, though I'm not sure what that means given there is no production stored in caves (only in houses). I suspect that means they sell financial assets at lower prices than they expect to domestic and foreign buyers. But again, I'm not sure what that means because presumably prices fall to discourage sales. I also agree the policymakers would love inflation over taxation. But increased taxation, which funds consumption with precious equity that funds and underwrite the discovery of innovation at the margin, instead of cheap debt, which seems inevitable given we seems unlikely to raise middle-class taxes cut first by Republicans (which I publicly oppose) and soon to be by Democrats (which is why Republicans never should have done it in the first place), will slow growth and subsequently inflation. Either way--taxation directly or through inflation--perhaps preferable through unexpected inflation IF it taxes bondholders, although presumably that just taxes future borrowers via higher interest rates, it will slow growth by increasing consumption relative ti investment. Regardless, these 3 aspects of the story of the economy--slowing globalization, demographics, and inflation/taxation--that must be told (by me) to get the story 100% correct, i.e. flawless."