The Fed Has Made Inflation the Enemy, but Should We Fight Inflation at All Costs?
An attempt to answer a thorny question.
At a time when the planet is panicking over soaring prices when central banks are raising interest rates like never before in decades at the risk of causing a recession, it is useful to ask the question in the title of this article:
Why, then, do we need to fight inflation?
The first answer is that you have to do it ... because you have to do it. Central bankers are mandated by law to maintain the stability of money - and thus to fight against its depreciation, which is reflected in rising prices.
50% inflation per month
But this answer is not satisfactory because the legal can be insane. A French law, for example, requires every French household to have a bale of straw in case the king should pass by on the back of a hungry horse, and no one cares...
Inflation is an economic phenomenon, so we must also find an economic reason. Let's leave aside hyperinflation, like the one that hit France during the Revolution in 1795, Germany in 1923, or Zimbabwe in 2008. It destroys finance and can break the economy, but it develops under very specific conditions.
Today, no country is approaching 50% price increases per month, a rate considered hyperinflation.
Social justice argument
The most obvious reason to fight inflation is that it creates a fog of uncertainty. Complicating calculations, it hinders investors and savers. This argument, which appears on central bank websites, has not been used recently. And economists have so far failed to prove that inflation is a drag on growth. At the central bankers' summer school in Jackson Hole in late August 2022, Jerome Powell gave another reason:
“The burdens of inflation fall most heavily on those who are least able to bear them.”
So the Fed chairman used a social justice argument, not an economic efficiency one, which is not common in finance.
Spotted in 1857
In doing so, Powell is following a pattern of continuity. More than thirty years ago, the director of the French Treasury, Jean-Claude Trichet, convinced the socialist Minister of the Economy, Pierre Bérégovoy, of the need to fight inflation by explaining that rising prices penalized the poorest.
Here again, the argument seems obvious. Inflation is now driven by energy and food. These two items account for 28% of the expenses of the least well-off and only 20% of the most well-off in a country like France. The poor therefore suffer more from inflation than the rich.
Nothing very new: the German statistician Ernst Engel had noticed that the share of the budget allocated to food decreases when income increases … in 1857.
A fascinating study
Economists have nevertheless published a lot of work on this effect of inflation in recent years. Most often they show that rising prices make the low-income basket more expensive, in a wide variety of circumstances: the 2020 confinements in the United States, the aftermath of the 1994 devaluation in Mexico, France from mid-2021 to mid-2022, etc.
Xavier Jaravel, a French economist at the London School of Economics, has done a fascinating study in the US for over a decade (2004-2015). At first, when you break down consumption into ten major items, inflation is experienced equally at all income levels. On the contrary, when we look much more closely at over 1,000 product categories, the purchasing power of the poorest is eroded more by rising prices.
Low wages protected
But that's only part of the story. Galo Nuño, head of the macroeconomic analysis department of the Bank of Spain, and a team of researchers have carried out a study that examines the unequal impact of inflation in Spain in 2021 through three mechanisms: the consumption effect, but also the income effect (wages and social benefits are adjusted to inflation with a delay and often partially) and the debt effect (debtors who have borrowed at a fixed rate pay back their creditors, who are often richer than they are, in depreciated currency).
Economists show that while the consumption effect penalizes the poorest, it is much weaker than the other two effects ... which affect the wealthiest more. In France, the same is probably true for the income effect at the moment. The lowest wages are protected from inflation by the automatic and rapid indexation of the minimum wage. Social benefits are also protected, albeit less strongly. Higher wages, on the other hand, are lagging.
Inflation does not therefore mechanically increase inequality. Everything depends on the forms of inflation, the indexation mechanisms, the countries, the wealth, the financial rules, etc.
Central bankers will have to find another good reason to fight inflation.
Some reading
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