The Limits of “Economic Orthodoxy”

Every year the executives of the US Federal Reserve System gather in Jackson Hole, Wyoming for an annual financial symposium. At this year’s meeting, everyone was expecting the position of Fed chief Jerome Powell. And the message from the American central banker was clear: at the moment the priority is to reduce inflation. The direction Powell insisted that although there is a slowdown in growth rates, the economy maintains strong momentum. For Powell, history teaches that it would be a mistake to “relax our policy prematurely” and there are three lessons from the experience of both the high inflation of the 1970s and 1980s and the low inflation of the past 25 years. Powell’s position, which essentially heralds a fairly long period of relatively high interest rates, actually reproduces a number of positions that are part of the “economic orthodoxy” as it gradually took shape from the late 1970s onward. It is a view that, without necessarily subscribing to the entirety of a monetarist view of inflation, nevertheless considers that central banks can deal with inflation in terms of monetary policy. Based on this scheme, inflation is basically a matter of imbalance between demand and supply, and the central bank has the ability to intervene on the demand side to reestablish equilibrium. By raising interest rates, it makes borrowing more expensive for households and businesses and leads to a reduction in demand both directly and indirectly as businesses are forced to lay off workers and unemployment rises. The reduction in demand in turn pulls prices down and restores equilibrium. The problem The problem is experience has shown that inflation is often a much more complex phenomenon than simply the existence of excess demand that needs to be tamed. For example nowadays inflation has not come from any great increase in demand. There was a seasonal increase in consumption after the exit from the pandemic and a renewed increase in consumption but it would be a mistake to consider that today demand is the main causal mechanism for the increase in inflation. Nor, of course, do we have inflation due to a large increase in labor costs. The increase in employment has also not led to much growth in wages, and any increases in wages are smaller than increases in the prices of goods. On the contrary, we have several indications that today the driving force behind the increase in inflation is from the supply side. This has to do with skyrocketing energy prices due to geopolitical disruption from the war in Ukraine, problems in various supply chains, and of course the fact that comparatively little investment in developing technological and organizational innovations to increase productivity of labor leads firms to raise prices to maintain high profit margins. In this sense, what appears as excess demand is actually a more general inability of supply to respond. And this can explain how phenomena such as growth rates in the US that are lower than the various predictions that had been made, falling labor productivity and of course increased inflation coexist.