Solutions to the Global Inflation Problem: Adam Posen / President, Peterson Institute for International Economics

Hello and welcome to DEEPER LOOK from New York.

I'm Del Irani, it's great to have your company.

As Russia's invasion of Ukraine continues, you may have noticed the cost of goods and services - like food, gas and other consumer items - have been rising.

Here in the United States, the measure of inflation, known as the Consumer Price Index, hit 8.6% for the first time in 40 years.

In an attempt to tackle this record high inflation, the U.S Federal Reserve raised interest rates by 0.75 percentage points -

that's the sharpest rise in nearly three decades...

But inflation is a global economic problem - with the costs of goods and services rising across the world...

surging in European countries such as the United Kingdom and Germany and across Asia-pacific as well.

So, what exactly is causing this global inflation and how do we tackle it?

Joining me now to talk more about this is Adam Posen.

He's the president of the Peterson Institute for International Economics.

From 2009 to 2012 he was an external voting member for the Bank of England's Monetary Policy Committee, and previously served at the Federal Reserve Bank of New York as well.

Welcome to the program.

Dr. Posen, great to have you with us.

Thank you for having me, Del.

So, can you put this in perspective; how serious is the current inflation problem here in the United States, compared to what we've seen in previous years?

It's obviously very different from 40 years of people being accustomed to almost no inflation.

But it's not so different.

We're not in a new era, I want to stress.

This is due to some circumstances of supply chains of the pandemic.

And, frankly, some errors the Federal Reserve made in not tightening sooner.

But within a year or two, we will be back to low inflation.

So, Dr. Posen give us a sense of what exactly is causing this inflation at the moment.

What's behind it?

I think there's three things at work, Del.

The first is everywhere in the world right now, we are experiencing the aftereffects of reopening COVID...

reopening after COVID's worst part, the supply shocks, the messing up of value chains, the bottlenecks of shipping, but also the terrible energy and food effects of Russia's barbaric invasion of Ukraine.

The second thing that's going on, which is specific to the US, is we were already on a strong recovery path, and at a relatively low level of unemployment at the end of 2020,

when the Biden administration and the Congress passed a big additional stimulus package, at the start of 2021.

Which would have been okay, if the Federal Reserve had offset that, but instead, they just sort of let it go.

And the third thing that's going on is we have this sort of momentum, unfortunately, in inflation.

That because of the mistakes made, then once we get these shocks, they build on each other.

So, people used to talk about a wage price spiral, we're not there yet.

But the idea is, once you have some inflation in the economy, the next inflationary push you get has easier to go.

Of course, Russia's invasion of Ukraine is playing a role.

We're also just starting to emerge from the COVID-19 pandemic.

To what extent, I mean, both of these factors are playing a role.

Is one sort of playing a greater role than another?

And I mean, can you explain, you know, how they're affecting inflation, I guess?

Well, it varies from country to country, Del.

So, in Europe, the energy effects of, and what's anticipated to happen with energy supplies, due to Russia is very first order.

And that is the major driver of inflation.

In the US, it's more to do with our labor market.

That, we had a situation where you have this huge rise in unemployment for a brief period, it was still very bad in human terms, but briefly, in 2020, up to 20% plus.

And then a bunch of people, rightly understood, "Hey, it's time for me to reevaluate."

"You have to pay me more to get me back in the workforce."

"Maybe I shouldn't change jobs, or change location."

And so that's a long process, and it's probably doing some good for a lot of people.

But in that process, we have a lot more difficulty putting people together with jobs.

There are shortages of certain types of workers in certain locations.

So that bids up wages, which isn't entirely a bad thing.

But when it's happening against this background of other inflation shocks, it amplifies it.

The Federal Reserve, right, increasing interest rates, because I just mentioned earlier that they raised interest rates by 0.75 percentage points.

How do you evaluate the Federal Reserve's response in raising these rates?

Has it been a little too little too late?

Or, what do you think?

It's not too little too late.

It's not as good as it would have been if they'd started earlier, because if they'd started earlier, maybe they wouldn't have had to go so fast.

Or more importantly, they wouldn't have to go so high.

Right now, the Fed is basically promising that barring some big new news, they're going to keep raising rates until they get to roughly three and a half percent

on the instrument interest rate, on the federal funds rate.

That is what we would call mildly restrictive.

That the interest rate would be tighter than what Federal Reserve and others consider neutral, which is the interest rate that's basically for a fully employed economy.

But it's not hugely high, because we're still expecting high inflation.

So, the real interest rate that people are being charged will still be negative.

So, it's a reasonable compromise.

And they can afford to tighten further, say, in early 2023, if this turns out not to be enough.

How long would it be before these measures start working?

I think there'll be visibly starting to work in the next few months.

There is a lot of uncertainty.

I know people are sick of economists saying that.

But if you don't say that, you're deluding people.

There's a lot of uncertainty, because it's essentially the big question is, how much is inflation in the US due to what we call supply factors,

which is real things like the amount of people available for certain kinds of work, or the amount of waiting time on ships, versus how much it's due to overheating.

Which is that people are consuming more than we can produce at a given time.

And we're not going to know the breakdown.

The more it's about supply and not demand.

The faster this may go away because we're starting to see all kinds of evidence that commodity prices are coming off the top, that shipping times are going way down.

The more its demand, it requires more pain before you get down.

So again, I'm hopeful that the next few months, we're already starting to see inflation peak.

And it'll be going down through the fall.

But it may not get down very low for at least a year.

Dr. Posen, there are concerns when you know, the Fed raised interest rates so quickly, that it might trigger a recession in the US.

What are your thoughts?

Which, which way is the US economy headed?

I think there's a rising risk of recession.

And I still think it's lower than 50%.

But it's getting up there.

It's one in three, or maybe even 40%.

In a normal year, the risk of falling into recession is roughly around 15-16%.

So, to give you a sense, a recession risk is more than double, in my view, what normally would be.

But it's not so much about the rate of rate hikes, though, although there's some issue there.

It's more about how high they feel they need to go.

So, if they get to the end of the cycle, say, what they've promised, which is - not promised - but what they've said they intend to do, which means getting to 3.50-3.75, in the first quarter of 2023.

And they're able to stop there, I think that a recession may be avoided, or it may be very light.

If it turns out that there's a lot of momentum in wage demands, pricing and the supply factors aren't enough to damp it down, then they may have to keep raising upwards towards 5%, from three and a half to five.

And then you're looking at a very real chance of recession.

When you talk about the rising interest rates, and this type of policy, what effect does this have globally?

I mean, specifically on developing countries.

Could it potentially cause a debt crisis in developing countries?

It's certainly going to cause pain in developing countries.

We know from past history, that when the Fed raises rates, a lot of developing countries hurt.

And this has to do with how much they're able to purchase in the world.

Because generally, when the Feds raising rates, the dollar rises against the value of their currency, so they have less purchasing power.

But it also critically has to do with investment.

That oftentimes when the Feds rates are low, developing countries borrow from abroad, sometimes dollars, and then they have to pay it back at higher interest rates in dollars

that are more expensive, and that contracts the economy.

So, we're gonna see problems.

But from a global financial perspective, or a global forecast perspective, it shouldn't be as bad as some past cycles when the Fed raised rates.

A large number of developing countries and emerging markets have been much more careful with their fiscal policies in recent years.

They've borrowed more in local currency and not in dollars, they've been more responsible about not over borrowing.

Then on the other side, there are countries like Egypt, or some of the countries in Central America that are facing incredibly difficult periods where food and energy are extremely expensive now,

and they're very dependent on foreign food and energy.

And so, they may have some real trouble.

So, Dr. Posen, if you could, I guess, you know, advise various governments right now, you know, around the world, what would you be telling them about the measures they could take from a fiscal policy perspective?

I wish I could be giving advice to the US.

Because of our political divisions it's very hard to imagine any fiscal policy getting through, however well designed.

But when we look at many of the economies in Europe, we look at Japan, we look up to China, there's a lot of room for things to do.

One thing to be done is you try to compensate the poorest people who are suffering under the energy shock, directly.

And that can be direct redistribution, that you tax or cut spending on richer people and just put more money in their hands.

It can also be part of a bigger deal.

So, in parts of Europe, they're talking about doing a one-off fiscal payment to people in return for the unions keeping wages down.

Not down, but keeping the wage demands down from increasing too much.

Because that is one time on fiscal year alleviating suffering, but you're not starting this inflation cycle again.

There's discussion about cutting energy taxes in certain places, including the US.

And that has its appeal, it's probably inflationary.

But you could argue because of the way the inflation numbers are constructed, that it will look like an inflation cut, because it pulls down the price immediately, for certain kinds of energy.

So, there are things that could be done on the fiscal side.

I think the most important thing is to continue, as we learned during COVID, to be aggressive about not letting people fall into unemployment and poverty.

That when they get displaced, that there is a strong safety net under them.

And do not be afraid to spend on that.

What are the risks to the global economy if inflation is not brought under control, if we cannot really start to reduce the cost of goods and services globally?

If we ended up with a period of globally higher inflation, meaning so something like we have now, and it's ongoing for a couple of years.

Then you start eroding a lot of stability in financial markets, of course, but more importantly, in politics.

And for that matter, in real business.

That what happens is - this is why people hate inflation so much - is when you have extended periods of inflation, you get all kinds of distortions.

People spend their time shopping for what they can get, companies spend their time trying to cleverly figure out ways to hide what they're no longer providing,

smaller packages, or longer wait times, or fewer choices for the consumer.

It distorts your whole economy, and it generally tends to lead to a lack of, a further lack of faith in your government.

Then you have the risk that generally inflation is good for debtors, which in certain circumstances is not so bad,

but will ultimately generally tend to drive up the interest rates on government debt.

Because people believe, start to believe the government's wanting the inflation, trying to drive down the value of its debt.

And so, they try to catch up by demanding higher interest rates.

And that slows growth for everybody irrespective of what the central bank does.

So going down a high inflation road is not a good idea.

And this is why all the central banks have come out and said "Okay, we're gonna stop this."

And that's why, ultimately people like me even if I care deeply, not wanting people to become unemployed, you ultimately have to do what you have to do to get inflation down

because the outcome for everybody's worse if it's allowed to persist.

Great stuff.

Dr. Posen, thank you so much for joining us on the show.

Thank you for having me, Del.

While we are ALL affected by the rising cost of goods and services...

Some parts of the world are feeling the effects much harder than others.

In times of crisis, it's easy to look inward and try to solve the economic problems at home first...

But policymakers need to keep a broader perspective, because the current inflation crisis is a global economic problem...

And thus the most effective solution, will likely be a global one.

I'm Del Irani, thanks for your company.

I'll see you next time!