"The great risk is to cause a recession trying to prevent inflation from perpetuating itself"

"The great risk is to cause a recession trying to prevent inflation from perpetuating itself"

Global agenda 23 February 2022


Rising inflation has become the main economic problem for Western countries. The Federal Reserve in the United States and the European Central Bank in Europe have been forced to progressively correct the low interest rate policy with which they have faced the economic impact of the pandemic. The goal: to prevent the price rise of recent months from continuing.

Toni Roldán, director of EsadeEcPol, and Francisco Vázquez-Grande, economist at the United States Federal Reserve, make an in-depth analysis of the rise in inflation in recent times, on the occasion of the publication of the economic report number 30 of Esade, which puts the focus on the post-pandemic recovery and especially the price increase that has been accompanied.


Toni Roldán: We're here with Francisco Vázquez-Grande. It's great to have you here. We're going to talk about a very important subject. I'll introduce our guest in a moment. Esade's 30th economic report talks about inflation, in a particularly sensitive moment and with many changes on the table. Last week, there was already new inflation data.

Francisco, who's with me, is an economist, he has a Ph.D. from Chicago University and he's also an economist at Fed. Welcome, Francisco. Thanks for being with us today.

Francisco Vázquez-Grande: Thanks, Toni. I can't wait to talk about this subject.

Toni Roldán: For you, what's the origin of these problems?

Francisco Vázquez-Grande: You need to think that, in the USA and Europe, we've had, at least since the Great Recession, inflation below the target of 2%. This has deep causes, such as secular stagnation, low real rates that we've seen since the Great Recession... And an idea that the economy's potential continued to increase almost faster than the product.

Based on these ten years, we have more knowledge of these errors in inflation prediction, especially in 2021. You have to think that, about a year ago, the consensus among economists close to public policy in the United States was that underlying inflation, which eliminates energy, was hoped to be below 4%. And in 2021, it ended at around 5%, which is a significant change. The objective is 2%, in the medium or long run.

This was a great surprise. And I think two reasons were behind it. One is the shock of the pandemic, which is a very specific shock, which closes the economic sectors that are more exposed to human interaction; while there are some that are still open, which are sectors where it's possible to work from home or even industrial productions that can be carried out more safely.

This supply shock in which a sector is closed internally produces a fall in demand and people lose their jobs, income is reduced, and purchases in the open sector fall. And this internal drop in demand is highly sensitive to being counteracted with public policy to increase global wellbeing.

That happened at the start of the pandemic. We see the biggest stimulus. In the USA, it's the biggest in history in direct transfers, in monetary policy actions, in the purchase of financial assets... This stimulus can possibly be appropriate for the internal shock in demand that we'd seen, but it meets this supply that's limited by the effects of the pandemic. It reduces the potential product.

So, the increase in actual product makes the Phillips curve come back and it becomes inflation. Talking about issues that are supposedly more temporary, such as energy, I think there's a certain consensus in that, at least, price increases due to energy it's harder for a central bank to act on them. It's more about, in the long run, the ability to produce more energy. But I think that, since COVID, there's been an increase in inflation excluding energy.

Toni Roldán: Yes, yes. That's the most worrying part. The other day, Jean Pisani-Ferry wrote about the different possible origins of this between the USA and Europe. There, there's been an extensive fiscal policy regarding what the economy was like at the time, maybe it was a bit smaller in Europe, with different policies. How you see those differences and are they relevant to today's debate?

Francisco Vázquez-Grande: As I see it, the two main differences are not about size, I think it was a bit bigger in the USA, but the composition of the stimulus is what's different. In the United States, there's been more stimulus in direct transfers, and there's been less, or less efficient, job protections. Meanwhile, in the Eurozone there's public policy infrastructure to implement a version of what's called an ERTE in Spain, which is done in all the EU countries, in the USA there have been programmes in that direction, but they haven't been accepted, they haven't been efficient.

Toni Roldán: There's a series of inflation effects that are redistributive, that can be relevant in this period. There's another series of effects in competitivity, if inflation is higher in one place than in another, for businesses, etc. What issues are they? To have a general picture of inflation effects.

Francisco Vázquez-Grande: Inflation is highly regressive because it's like wealth tax on liquid assets. So, in that sense, it's negative. There's also a problem in expectations, it's harder to plan, specially if it's highly variable, and at higher rates it tends to be more variable.

All of the Western monetary authorities are very worried with the recent rise in underlying inflation. I think the main objective for this year and next year is stopping this from becoming self-perpetuating expectations. Then, another great risk is that, to stop this from happening, a recession occurs at some point.

Toni Roldán: In a world where you've had cheap money, you've created huge debts of more than 350% of global GDP... There's been a series of bubbles, I don't know how relevant this is, associated with the increase in monetary policy, like cryptocurrency. Tell us how you see it.

Francisco Vázquez-Grande: Firstly, I don't think that monetary policy in the Eurozone in recent years is a cause of certain financial bubbles. However, it's true that the rates are very important. One hopes that the increase in the rates makes asset values fall in general, specially if they don't increase cashflows at the same time.

I think there are two ways of looking at it. Less in academics, I believe in central banks. But the Central Bank needs to react to the increase in speculative prices and not be governed by fundamental changes in the expected cashflows.

Then, the Central Bank has a branch of macroprudential regulation, where it doesn't need to react as much with interest rates in price changes, but it must regulate so these increases in assets aren't too supported by debt, so these bubbles aren't too "settled".

Toni Roldán: We talked about debt, maybe from the Spanish perspective. There's a very high level of debt here that, suddenly, can become, if the premium increases by 100 points, a serious problem for the State and the cost of debt will increase to 40 or 50 billion very quickly.

In a circumstance like the one we're in, it can dwindle economic growth. There's also an issue of differential inflation regarding other countries.

Francisco Vázquez-Grande: Spain is like an actor that asks for a loan in Euros and it doesn't have an autonomous monetary policy, but the government doesn't extract revenue from seigniorage. So, in a country like Spain, before a rate increase on its debt, it must fund itself with more taxes, with less spending or with more debt.

I think we're still in a world with highly negative real rates. It isn't the time to go towards an inflationary bad balance, or it doesn't seem it. And this debt is sustainable at relatively low rates. In the short term, it doesn't seem like it'll be a restriction for Western public policy.

Toni Roldán: With regards to the path or the vision of monetary policy in Europe, how do you see it? Are there any changes? From a historical perspective, what does it mean compared to the USA?

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