It’s far too early to declare the end of inflation

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Good news has strange effects. After just two months of encouraging US price developments, there is much talk about the death of inflation and the lessons to be learnt.

Financial markets are betting on a soft landing of lower inflation without recession. Economists speak of “immaculate disinflation”. Some go further, projecting US success in beating inflation will apply everywhere. There are even mutterings that inflation was, after all, transitory and that the seemingly painless decline in US CPI inflation should force a fundamental rethink of economic theory. It has been hot in many parts of the world, but people are getting a little overexcited.

Some facts are needed to frame the debate. Falling US CPI inflation from a peak of over 9 per cent to 3.2 per cent in July this year cannot mask the huge overshoot of prices compared with targets. Over the past two years, this headline measure of US inflation has risen 12 per cent — an annual rate roughly three times faster than the 2 per cent the Federal Reserve desires. In the eurozone and the UK the increases over the past two years have been even higher, at 14.6 per cent and 17.6 per cent respectively. At a minimum we have had almost six years of expected inflation in just a couple. Prices are rising slower, but they are not falling back.

Everyone expected much of the rise in prices after the dislocations of the pandemic and Russia’s invasion of Ukraine to be temporary. The worry was always that inflation would not fall all the way to the 2 per cent targets on its own and could become quite sticky on the way down. That is exactly what is happening and still the concern. Even after the latest good data, the Fed’s inflation forecasts for the end of this year, next year and the one after are unlikely to improve much. All the main errors have been in underestimating inflation’s strength and persistence rather than overestimating it.

Despite the sharp fall in the headline rate, the US economy still appears to be running hot and the labour market has not yet come back into balance. As members of the Federal Open Market Committee acutely observed at their latest meeting, “nominal wages were still rising at rates above levels assessed to be consistent with the sustained achievement of the committee’s 2 per cent inflation objective”.

If the US has seen some encouraging trends without sufficient progress, Europe has not yet followed. The European Central Bank had to raise its forecasts of inflation in its latest predictions and measures of core inflation have become sticky. And while it is possible for UK statisticians to construct measures showing underlying inflation beginning to fall, most data points still indicate a post-Brexit entrenched wage price spiral. Definitions of price stability do not include services inflation still running at 7.4 per cent in July, with annual wage growth over 8 per cent. This is not the environment in which it makes sense for European central banks to declare victory over inflation.

The central banks have, of course, become active inflation fighters over the past 18 months. A 5.25 percentage point rise in borrowing costs in the US, 5.15 percentage points in the UK and 4.25 percentage points in the eurozone are cooling labour markets, with vacancies falling and unemployment rising in some countries. Much of their effects is still to be felt.

The facts do not suggest there need to be many more interest rate increases to defeat inflation. But with underlying inflation still too high on both sides of the Atlantic, there is almost no coherent case to be made that the vast majority of this monetary tightening was ill-conceived. We cannot know how the major Atlantic economies would have fared had central bankers done nothing, but there is little doubt that excess demand would be stronger, inflation higher and the problem of persistent price rises would be worse.

The steps they took to contain inflation were therefore almost certainly necessary and there is little case yet to shout mission accomplished. But one aspect of the fight against inflation has surprised almost everyone — its lack of pain. Unemployment in the US is touching record lows and has barely risen in Europe. The jobs market has defied expectations in a good way as interest rates have risen.

Tempting as it might be to say that disinflation can therefore always be painless and we need to rewrite the economics textbooks, this appears to be a case of special post-pandemic circumstances rather than a theory-defying episode.

During and after the pandemic, the world suffered many supply-side shocks that contributed to the initial rise in prices. These occurred globally in gummed up and less efficient supply chains, in catastrophic rises in wholesale gas prices in Europe last year and in declines in US and UK labour force participation.

Many of these have been fixed or ameliorated, helping to bring down inflation with less pain than normal. This is far from bad news for economics because theories of price are always determined by both supply and demand. Supply has improved, demand has been held in check with tighter monetary policy. It is far too early to be mulling the future of macroeconomic theory. The question now for the US and elsewhere is whether interest rates are roughly right or need to be edged a little higher.

chris.giles@ft.com