To be clear, huge macroeconomic support is unequivocally needed now and for the foreseeable future. The pandemic-induced recession is worse than the 2008 global financial crisis, and parts of the US economy are still in desperate straits. Moreover, despite promising vaccine-related developments in the fight against the coronavirus, things could get worse.
Against this backdrop, the real inflation risk could materialize if both central-bank independence and globalization fall out of favor. In the near term, policymakers are right to worry that, if the economy continues to heal, stimulus measures and consumers’ cash savings will fuel an explosion in demand. But this is unlikely to lead to an overnight inflation blowout, mainly because price growth in modern advanced economies is a very slow-moving variable. Even when inflation reached double digits in many rich countries in the 1970s (and rose above 20% in the United Kingdom and Japan), it took many years to collect a full head of steam.
This is mainly because the speed at which prices and wages rise is acutely sensitive to how workers and firms view the economy’s underlying inflation dynamic. That is, today’s inflation is very much influenced by long-term inflation expectations.
That reasoning may seem circular, but it reflects the fact that, in many sectors, firms are reluctant to raise prices too aggressively for fear of losing market share. So, if central banks can succeed in “anchoring” long-term inflation expectations at a low rate, they can put the brakes on any prolonged inflation outburst. And today, years of ultra-low inflation are firmly embedded in the public psyche.
All this implies that even with rapid economic normalization, pent-up demand and large fiscal stimulus will not trigger an immediate spike in inflation. But if politicians undermine central-bank independence and prevent a timely normalization of policy interest rates, even deeply ingrained low-inflation expectations could fray.
The other long-term inflation risk is subtler, but potentially even harder to forestall. Many people are vastly more skeptical about globalization today than they were three decades ago, largely because evidence suggests that the wealthy have benefited disproportionately from it. While stock markets have soared, labor has been receiving a declining share of the economic pie. And many of the proposed measures that might enable workers to claw back a bigger cut, such as boosting unionization and making offshoring more difficult, will necessarily mean a reduction in trade.
A reversal of globalization could have a big impact on inflation. Many Westerners fear that China will “eat our lunch,” as US President Joe Biden recently warned in calling for a much-needed increase in infrastructure investment in America. Maybe, but Westerners need to recognize that when it comes to global manufacturing, China is the one making lunch, and the meal would cost a lot more if it wasn’t.
More broadly, central banks’ disinflation efforts from 1980 until the 2008 financial crisis benefited enormously from the hyper-globalization taking place during this period. Trade with China and other developing countries, combined with technological advances, relentlessly drove down the prices of many consumer goods.
With productivity rising and many prices visibly falling, for reasons beyond monetary policy, it became relatively easy for central bankers to move the public’s long-term inflation expectations downward. But when I pointed this out at a major conference of central bankers back in 2003, in a paper entitled “Globalization and Global Disinflation,” most of them did not really want to share credit with globalization.
Things could now move in the other direction, especially given the strong bipartisan political consensus in Washington on the need to challenge China. The substance of Biden’s policies may not differ from those pursued by former President Donald Trump as quickly or as radically as many internationalists might hope. And even if the US and China manage to patch over their current differences, globalization’s impact is set to fade, owing in part to demographic factors, as Charles Goodhart and Manoj Pradhan have forcefully argued. China’s labor force, for example, is projected to shrink by 200 million over the next two decades.
So, should markets be panicking about a possible spike in demand driving up inflation and interest rates, causing asset prices to fall across the board? In the near term, not so much. It is even possible that a year from now, central banks will be seriously considering deeply negative interest rates in order to rekindle inflation and demand. And it would not necessarily be a bad thing if inflation were to rise above target for a couple of years after being so low for so long. But longer-term inflation risks are skewed much more to the upside than markets or policymakers seem to realize.