Credit Where Credit Is Due

Inflation has fallen just about as fast as it went up, going from 8.1% to just 1.6% in the span of two years. The mechanics of that sharp decline are both simple and complex at the same time.

Pandemic-related supply chain disruptions and pent-up demand have both faded, even if they took longer than anticipated to turn a corner. Labour shortages are a thing of the past, as businesses and workers found each other after settling into the new post-COVID world. On the surface, it’s a simple story about transitory disruptions and reorientation. However, that ignores the important role that anchored inflation expectations played.

The fact that households and businesses believed that inflation would eventually return to a lower trend kept their spending and investment in check. If consumers believed inflation was going to remain high, they would have rushed to make purchases before prices rose further. Firms would have responded to the increased demand by raising prices even faster and attempting to add more labour and capital. Hiring and investment would have pushed up wages, and an ensuing wage-price spiral could have taken hold.

Such a scenario didn’t play out because of the actions taken by both current central bankers and former policymakers. Aggressive rate hiking cycles not only cooled off overheated economies, but served as a stark warning for those that might have believed monetary policymakers weren’t committed to containing price pressures. Global central bankers seemed willing to accept recessions in their local jurisdictions if it meant controlling inflation. These actions were informed by the successes and failures of central bankers over the past 100 years.

Formalized inflation targets, increased independence and three decades of success in keeping inflation low had shown the ability of the current central bank model to maintain price stability.

Throughout the world, governments of all political stripes seemingly abandoned perceived fiscal constraints, driving inflation rather than cooling it in recent years. However, most governments should get credit for maintaining the institutional independence of their central banks through the recent hiking cycle. At a time when populism has left fiscal conservatism in the rearview mirror, the independence afforded to developed market central banks proved absolutely necessary to contain inflation.

The Nobel prize in economics was awarded to Daron Acemoglu, Simon Johnson and James Robinson this week for their research showing that strong domestic institutions increase the likelihood of economic prosperity. On that note, one of the most important implications of the upcoming US election for financial markets will be whether the winner maintains the independence of the world’s most important central bank.