Is higher inflation inevitable? My long-read Q&A with Charles Goodhart and Manoj Pradhan
By James Pethokoukis, Charles Goodhart, and Manoj Pradhan
Since the 1980s, the United States has prioritized low inflation, to great success. Policymakers have regularly kept inflation at or below their 2-percent targets, even during periods with record-low interest rates. As a result, many policymakers have been — and continue to be —comfortable with spending trillions of dollars on various legislative priorities. But what if the low inflation we’ve experienced has been temporary? What if an aging workforce and diminishing returns from globalization will cause wages and prices to begin rising more steeply? I recently explored these questions with Charles Goodhart and Manoj Pradhan.
Charles is a financial markets professor emeritus at the London School of Economics, and a former member of the Bank of England’s Monetary Policy Committee. Manoj is the founder and chief economist of the independent macroeconomic research firm Talking Heads Macro. They are the co-authors of The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, released last August.
What follows is a lightly edited transcript of our conversation, including portions that were cut from the original podcast. You can download the episode here, and don’t forget to subscribe to my podcast on Apple Podcasts or Stitcher, or download the podcast on Ricochet. Tell your friends, leave a review.
What is the current consensus on inflation? It seems like it’s almost treated as anachronistic, like it’s a concern from a different era that is now a low priority. What is the consensus from your perspective?
Goodhart: I think you’re absolutely right about that. And indeed, it’s an extension of what has been happening for the last 30 years since about 1990 — inflation has been coming down steadily and has remained very low. The general assumption that people have is that unless something remarkable happens, the world will go on much as it has in the past.
There’s also the view that inflation was reduced to these steady, low levels because of better monetary policy and the central banks will be able to continue holding inflation down. In our book, we challenge both those views.
So the current view is that low inflation was a great central banking success, and if inflation pressures were to reemerge central banks would know what to do. They have a protocol and would be able to suppress inflation and inflation expectations, so it’s no big deal.
Goodhart: I think that’s right. But that view is unduly complacent. People now have largely forgotten how difficult it was to turn inflation around at the end of the 1970s and how much courage Paul Volcker, Ronald Reagan, and Maggie Thatcher had to extend to do so.
In many ways, it was actually easier to turn inflation around then than it would be now. Now, the debt ratios are so much higher, the fiscal implications for the budget are raising interest rates, and the implications for heavily indebted private companies are much greater than they were previously. It would actually be quite a difficult job to turn around inflation at this moment, and it will be against the instincts of many politicians for interest rates to go up (other than glacially slowly).
Pradhan: I’ll add that the reason why central banks have picked up so much credibility is because there’s been an ongoing debate that the Phillips Curve is dead and, as a result, central banks don’t have to worry about inflation — all they have to worry about is growth. If growth goes down, you cut rates. And if growth looks like it’s overheating, you raise rates to slow things down. It makes their job relatively easy.
But as James Bullard said about a decade ago in an interview with NPR, “Well, the Fed has a responsibility for killing the Fed.” Forgetting the Phillips Curve, that’s what we are disagreeing with. We think it’s China that put the Phillips Curve in a coma, and it’s the pandemic and the demography that are going to revive it.
If you look at China, there’s a broad consensus that it was a massive disinflationary force. China allowed the US and other advanced economies to focus on consumption. It did enough investment for the entire global economy and kept the average global composition of growth pretty sound. But that growth was really just investment in China and consumption in the advanced economies — prices were coming down because China was a very low-cost — and increasingly more adept — technology manufacturer.
This all really worked against what you would see in the Phillips Curve. The Phillips Curve predicts that, as growth gets better and better, inflation resurfaces. But in this situation, we had China dis-inflating the world as its labor force got integrated. Unfortunately, the central bank’s models could not really catch that because demography is a very slow-moving variable. Their forecast’s horizon span is two to three years and depends on the plugging in of expectations which, over the last 30 or 35 years, have shown an econometrically significant falling trend.
So then the question became, who do you attribute it to? And central banks naturally said, “Well, it’s our inflation-targeting regimes,” and so on. They were not wrong, but they were not fully right either. Once this story reemerges, the challenge for central bankers will be to accept that they weren’t responsible for 100 percent of the disinflation and so they cannot control 100 percent of the inflation that’s going to come.
And given what we’re seeing right now — the dominance of fiscal policy, the strength with which it’s shown up, and the secondary role monetary policy is playing — this story is going to be revived a lot faster than people think.
So you both essentially argue that the common story regarding rising inflation and interest rate change — which paints a victory of central banks — is only a part of the story. The other extremely important part of the story is that this labor supply shock was driven by all those Baby Boomers entering the workforce and the entrance of China and Eastern Europe (after the fall of the Soviet Empire) into the global labor market. But there seems to be a lot less talk on that big labor supply shock. Is that right?
Goodhart: Absolutely correct, but there’s another element in it too. Declining birth rates and the rise of consumer durables — washing machines, refrigerators, and so on — allowed an enormous number of women to join the workforce who would otherwise have worked entirely on home activities. It was not only the fact that the Baby Boomers were joining the workforce, but also that the female half of the population was working in paid employment instead of being at home looking after their children and washing clothes.
So the impacts of this immense amount of labor entering global labor markets were weak worker bargaining power and deflation on wages, resulting in low inflation on wages and prices?
Goodhart: Absolutely correct, that’s basically the story. Remember, earlier you said that central banks gained credibility because they had to raise interest rates to lower inflation. In reality, they didn’t. Since inflation targets were put in, interest rates — both nominal and real — have been trending downwards fairly steadily. Even after the Great Financial Crisis, during which the kitchen sink was thrown at expansion, central banks have not been able to raise inflation back to target. This all means that there were very strong disinflationary forces lurking in the background.
When people say that central banks know how to deal with inflation, remember that only 20 years ago virtually every economist in the world would’ve said that a central bank can easily deal with deflation that — all it’s got to do is create money. Yet that hasn’t actually been working all that well because of the very strong underlying disinflationary forces. And the trashing of labor bargaining power due to this huge labor supply shock was one of these forces. There has never been such a large, positive labor supply shock for any employer who can shift production to a low-wage center. The labor force more than doubled over 30 years.
The only equivalent labor force change was when we had the Bubonic Plaque back in the 14th century. There, the labor force virtually halved, and the immediate result was higher real wages and, under those circumstances, lower asset prices as well. Now we’re going to see the reverse.
Pradhan: We also hear a lot of talk about the introduction of technology being highly disinflationary. I want to add that, actually, that is precisely what China also did. Think about the complete transformation China’s capital stock has undergone over the last 30 or 35 years since its opening and joining of the global supply chain. What they were doing was not only introducing a brand new vintage of capital-embodied technology into the global economy, but also combining it with one of the most well-trained and lowest-cost workforces in the world. They introduced a brand-new production function into the world, practically out of thin air.
So while we’re talking about labor supply, the element of physical capital with Western expertise joining China’s production facilities should not be underestimated. That’s a really big part of the story.
But your book argues that this core dynamic, the one we’ve been discussing, is reversing. Tell me about this reversal.
Goodhart: First off, demography has clearly reversed in regards to ratio dependence, particularly with the old. The old actually consume more than those who are working age, as they consume a lot of public goods — Medicare, Medicaid, Social Security, pensions, and a great deal of care. Now, over half the older population actually needs some outside assistance in undertaking the normal activities of daily living, so the surge in the proportion of those who are actually working in the population is going to reverse.
Beyond that there is, for obvious political reasons, a decline in globalization. While some might have originally said that decline would be quite small, one of the effects of the COVID pandemic has been a reinforcement of the idea that a central manufacturing production — of many kinds — ought to be included within national borders. Think about the concern around having enough production of vaccinations in your own country.
So looking back at this idea of reversal, we’re soon going to see the bargaining power of western labor markets increase and the current portion of the population producing within the working force instead become consumers. Does that mean that a lot more demand will be put in the economy and, as a result, we’ll have higher inflation?
Goodhart: Yes. But one of the things that we never knew was when this would happen. The bargaining power of labor has been really vastly reduced. About 40 years ago, private sector trades unions were a power in the land. Now, unions like the National Union of Mineworkers, which was dominant in my own country at one point, no longer even exist. Bargaining power has particularly gone down as production in the advanced economies has shifted from manufacturing to services.
We thought that we didn’t really know how long these underlying demographic and globalization trends would take to reverse, or how long it would take before they led to a much greater inflationary context. We were sure that it would come, but our concern was when. Then came COVID. I think that the policy responses to COVID — combined with the reversal of the underlying trends from disinflationary to inflationary — are going to cause higher inflation to kick in much earlier than central bankers now predict.
Pradhan: Jim, I think your intuition on consumers and producers is spot-on. In many senses, that’s one of the key frictions in the composition of aging, one that has probably been, and will be, responsible for the changes in inflation. If you think about dependents, they typically have a consumption profile. As Charles often argues in our seminars, it’s not that the aged consume less — consumption actually rises, considering government aid — but that they don’t produce anything.
The people who are working, including those who participate to a greater extent later on in their life, are disinflationary for two reasons. The first is that they are paid less than the value of their work, which is how the economy works. And second is that they end up saving for retirement. If an increasing number of workers who share that profile join the labor force or come to dominate the labor force or population, then the disinflationary numbers tend to move in the ascendancy, which brings overall inflation down. But now, the part of the population that is going to come to dominate doesn’t really consume. And equally importantly, it’s not the young but the old — once they end up consuming the goods and services that they need for later on in life, unlike the young they’re unlikely to re-join the labor force again.
Obviously, we’ve just had an inflation scare. But what’s different now is that both main indicators of inflation have picked up so much steam that it’s very difficult to see them pointing in the same direction next year, which is precisely when central banks expect inflation to come down.
If you look today, monetary aggregates are actually at very high levels in many economies. In some, they are at levels that we have not seen in the last 40 or 50 years. In the US, for example, M2 growth is at 25 percent — the previous peak was 10 percent. In Japan, the previous peak about 30 years ago was 5 percent because of all the QE they did. Right now, M2 is growing at 10 percent there, so it’s not surprising that their breakeven numbers have gone up.
Next year, the decline in velocity that has been, in a sense, holding monetary aggregates back will normalize, as we’ll hopefully start living more normal lives. And at the same time, that massive pool of personal savings that we’ve seen accruing — some of which is already getting deployed into housing — will start to be spent, either in goods and services or a little bit more into housing. That will cause the output gap to close very quickly.
By the time you get to 2022 — either the beginning, the middle, or the end — it’s likely you’ll see monetary aggregates and the Phillips Curve pointing in the same direction towards higher inflation. And that’s interesting, because 2022 is precisely the time at which the Federal Reserve claims inflation will come down.
Manoj, you used the phrase “inflation scare.” Unless you’re talking about hyperinflation, I think a lot of people are going to hear this and think about accelerating wage growth, which sounds like good news. We’ve all heard about slow wage growth or wage stagnation for decades — it’s a very common story from politicians on both sides of the aisle. So are you telling me a good news story or a worrisome story?
Pradhan: It depends on who you’re looking at. If you’re looking at the parts of the labor force that have seen stagnation before and were not able to keep up with purchasing power like the rest of the economy, it wouldn’t be too bad. It wouldn’t be bad because, in that instance, you’re not talking about it within the context of greatest growth but rather within-country inequality. So in that case, it results in something that has been a scourge in the global economy for a while actually coming down. That’s the good news.
If you’re talking about productivity, we do think there is going to be greater productivity. Not massively so — we’d be very well placed to try and even come close to what Japan has delivered over the last few decades. But if you start thinking about the broad effects of inflation, they will definitely be welcomed by everyone initially, because we do need it. I’m sure you have debt in mind as well — it lowers the real burden of debt and does a lot of other benign things. Essentially, it greases the wheels of the labor market.
But once it eventually starts getting into things like financial markets or people’s earnings quality, it has significant attritional effects that make it very difficult. The most difficult question of it all is going to be, what are the central banks going to do? The governments will welcome it, because they’re the ones issuing debt. But the central banks — this goes against their religion. And if they start to fight inflation, I fear that the ill effects from the slowdown they will try to induce will be very hard.
Basically, this will be an attritional story that, over a period of time, will start showing more and more ugly parts. But I think you’re absolutely right that in that the early stages of this, it will be welcomed as a huge success of central banks by financial markets and almost everyone else.
Is this also a story of higher interest rates overall? It seems like the assumption that inflation’s forever going to be low is paired with an assumption that very low interest rates make it very easy for governments to borrow.
Goodhart: It depends on the numbers. As Manoj has said, inflation will be welcomed as long as it’s below 4 percent. They won’t do anything if it’s below 4 or 5 percent, but over 5 percent they will start worrying. But then again, there is a predicted blip in inflation sometime in the year after we all get vaccinated and life returns to something like normal. And the central bank claims that, after that blip, inflation will go back to 2 percent.
But given the massive increase in monetary growth we get when output rises so fast that the output gap closes and unemployment goes way down, the idea that it’s all going to then slump back towards 2 percent seems unfeasible. Considering the policy measures and change in underlying labor trends we expect to occur by the end of 2022 and beginning of 2023, central banks will start to worry if that return to target will occur. And again, will inflation expectations become unhinged by then?
I think, as Manoj said, the first few months of above-target inflation will be regarded as splendid — average inflation targeting and all of that. But then it becomes a question of numbers and how long the inflation remains above target.
Pradhan: Another thing to keep in mind here is that financial markets are very impatient. They want all the answers and they want them now. They probably wanted them yesterday. And they’re very skeptical that everything will go according to plan, because it’s become a bit of a pattern over the last couple of decades that things won’t. So they’ve already started wondering if central banks do have it under control.
There’s a range of inflation trends and peaks within which the central bank can still get away with saying “Okay look, this is the service sector returning to normal. They’ve lost a lot of revenue, they have to mark up prices.” And that’s absolutely right, but beyond a certain range — as Charles was saying, probably 4 to 5 percent — it will be very difficult for the central bank to justify it.
And in anticipation of that, we’re going to see the bond market say one of two things, we just don’t know which. It could say “Well, if the central bank is not going to do what I need it to do, I’m going to do it myself, which is that I’m going to raise bond yields and make it difficult for the economy to overheat.” Or, it might say “I’m anticipating that the central bank will remain very easy at the moment, but over a period of time there is the distinct possibility it will have to raise rates far faster than its got in its little dot plot, which that means it’s going to have to really catch up with the speed that I’m pricing into markets right now.”
So markets are going to try and do the tightening for the central bank. Or they’re anticipating the central bank’s actions — it’s hard to tell which. But the bottom line is, they are going to tighten financial conditions. And the more inflation surprises, the tougher it will be. Of course, the converse is true as well. If inflation doesn’t really rise much, if it peaks at 2 or 2.5 percent, then this inflation scare will truly be more of a scare than a reality, and we’ll have to wait and see if our demographic story holds true over a longer period of time. While I don’t think that’s going to materialize, it’s something we are keeping our eyes open for.
So why aren’t other macroeconomists talking about this? Certainly they’re aware of the massive labor supply shock that has gone on over the past generation. Why aren’t they worried about this shock reversing? As we mentioned earlier, the consensus seems to be that these are problems not worth really giving much attention to.
Goodhart: There are a number of reasons. One is that our story is global, whereas people tend to think only in terms of their own nation state. So the effect of China, which inflated the world, has been ignored. Moreover, all the Phillips Curve stuff concentrates on the level of employment and unemployment relative to inflation in one country. But given globalization, you cannot really do that. Economists have been far too based in their own nation state, rather than looking globally.
They’ve also tended to focus on the short-term rather than the medium- and longer-term. If you’re only focused on the next two or three years, you can easily ignore demography, as it is very slow moving. It started to change in 2010, but it’s only beginning to pick up steam right now, especially as a lot of working forces — forces particularly in Europe and China — are absolutely declining.
Where are we going to get the people to serve in care homes or do all of the actions needed in service economies? They are going to be far and few between, which is effectively going to force wages up as people chase for labor.
But what about automation? Aren’t we on the verge of an AI revolution that’s will allow machines to do a lot of what workers can currently do and produce goods far more cheaply? Might we be entering a period of deflation and lower worker wages as a result?
Goodhart: Well, we’re not experts in technological development. All I can say is that experts in this field are very divided on the topic. There are some, Bob Gordon for one, who think that all the low-hanging fruit has already been picked and it will actually be much harder to get technological innovation in the near future. But there are others, say Brynjolfsson, who take exactly the opposite view.
Our view of the future and the problems of an aging society are somewhat pessimistic. We would be only too pleased if we turned out to be wrong, either because technology turned out to be much more productive than we expect or if, for example, medicine has a breakthrough so that fewer of the old need continuous care and support by those who would otherwise be working more productively in the labor force.
Pradhan: One way to try and splice the technology argument is to consider, in line with what Charles was saying, that we depend on technology destroying jobs. Rather counter-intuitively, you’d be thinking that we’re technology pessimists. Actually, we don’t know enough to call ourselves optimists or pessimists. But here’s our line of thinking.
We start with the tension. We’re arguing on the one hand that we’re going to run out of workers, while on the other hand technology will cause us to run out of jobs. Surely the answer lies somewhere in between. What we argue is that people have not yet factored in — perhaps because it’s moving so slowly — the fact that, as our societies age, the demand for workers to look after the elderly is going to be gigantic.
There’s a very recent paper from the National Bureau of Economic Research that looks at the role of robots in nursing homes in Japan. One striking conclusion from that paper is that the use of these mini-machines (the proxies for robots) did not reduce the need for workers and nurses to look after the elderly. They made their jobs more efficient and helped reduce injuries, but you still need people to look after the elderly.
If you start on that basis — and factor in the fact that this is not a climate conducive to massive immigration, which could’ve been one solution — what you’re going to need is automation, robotics, AI, and all these other things to destroy less productive jobs in the rest of the economy. Because at that skill level, one of the things that you could easily think about doing is moving across into caring sectors and helping to look after the elderly. They’re not what you’d call economically productive services, but they’re socially productive services. They’re not economically productive because the elderly will consume them but won’t go on and join the labor force again to produce other goods. But these sectors are going to be required, and we are going to need more people for them, which means that we do need machines to destroy jobs in other places to allow for that reallocation of labor from one place to the other.
We’ve seen a huge demographic reversal in Japan and a shrinking workforce, but we have not seen inflation. Is the fact that we’re not seeing any of this playing out in Japan a counter-argument to your thesis?
Pradhan: It’s an incredibly powerful argument. In fact, it was so powerful that, when writing the book, we used that example to try and figure out if we had a thesis at all. We have an entire chapter titled, “Why Didn’t It Happen in Japan?” So I think you’re asking absolutely the right question.
In the past, I think this question has been answered in what we consider to be a less-than-satisfactory way. For example, we think the general the story is that people have looked at the demography and economic outcomes in Japan — which have been low inflation, weak growth, and falling interest rates — and they’ve said, “Well, one must have caused the other.” However, that’s not what you should be arguing in a globalized world.
Japan is a very open economy, but it’s very close to their gigantic neighbor, China. In fact, when you look at the timing, what happened in Japan is no surprise: Right at the time that Japan’s demography turned south, China was busy disinflating the entire world.
Goodhart: Exactly. So what was happening in Japan was happening around the rest of the world too, in that there were these very strong underlying disinflationary forces coming into play largely driven by China, Eastern Europe, and the other low-wage economies entering into the world’s trading economy. There was no way that Japan was going to be able to buck that.
Moreover, there’s a picture of the Japanese corporate sector being overburdened by debt and not being very strong. But what the Japanese corporate sector did — and this is research that was undertaken by Manoj at the Ministry of Economy, Trade, and Industry — was that they invested very heavily and produced a massive amount of goods abroad, which they then brought back into Japan and elsewhere.
And they kept much of the profits abroad as well, so the manufacturing sector in Japan (as in other advanced economies) shifted much of their production into China and other local low-wage economies like Vietnam. That meant that a great deal of the labor force was shifted into services — particularly into part-time services, where wages were considerably lower and the bargaining power of labor was even less than usual.
So what then occurred was that hours went down because of the part-time workers, not because of unemployment. To an extent, the low unemployment figures actually hide under-employment in Japan during this period. Basically, we believe that the story in Japan is pretty much the same story that hit the rest of the advanced economies — particularly in the years since the Great Financial Crisis — only it happened earlier.
Pradhan: And the evidence for this is in the timing. If you look at the global footprint of the things that happened in Japan, you’ll see a lot of those footprints elsewhere as well. If you look at the Japanese debt story, one of the key things widely noted is that, as corporate debt went down in Japan, the government borrowed very heavily. And of course, they could do so because their borrowing costs were falling down over a period of time. If you look at the other advanced economies, you’ll see exactly the same footprint over exactly the same time period.
Another thing to keep in mind is that Japanese productivity essentially moved in the direction that we would expect it to. You had growth with an average of about 1 percent and the labor force falling by about 1 percent a year, which led to a 2 percent change in productivity. That’s remarkable — advanced economies would bite your hand off if you offered it to them.
So that’s the story playing out in the background: Japan kept the higher end of the manufacturing side while some of the services were kept at home. But as Charles said, the Japanese corporate sector saw exactly what was going on. With China emerging as a dominant player, they moved their activities over to take advantage of the size of that market and the cheap size of the labor cost. And the sector recognized that Japan was going through a difficult time, which is why investment and spending over there was not booming, relatively speaking.
The Japanese corporate sector actually did very well — we’d be lucky to get by doing as well as they have done. But Japan’s not really a roadmap, as it happened at a very different point in time and under very different circumstances.
In the US, federal debt — while rising before the pandemic— is going up very fast right now. There are expectations that it will continue to increase at levels we haven’t seen since World War II and beyond. If you’re right, should I be concerned about the amount of debt that the US government is taking on?
Goodhart: Concerned, but not despondent. The continuing public sector expenditures on an aging society mean that a much higher level of taxation will have to be imposed on what will become increasingly a smaller proportionate working group. The problem there is that taxes are always extremely politically unpopular. So because of the unpopularity of taxation, the high debt burden, and high interest rates — occurring in any manner besides very slowly — we ultimately think inflation will rise. Politicians just will not be able (or prepared) to raise tax rates sufficiently to bring what is currently a very large primary deficit back into balance, or even a small surplus.
Pradhan: I think it’s a difficult proposition to deal with debt. One of the issues that Charles points out very beautifully is that most people look at debt and they say, “Look, debt has been higher in the past.” Yes, but that has been around specific events. If you look at the projections of the CBO or elsewhere in the advanced economies, you can see very clearly that a lot of the increase in debt is associated with looking after an aging population. And with that, there’s really no end in sight.
Clearly, the path towards reducing the burden of that debt has to be faced through inflation. And part of that story, at least in my personal opinion, is going to be played out through central banks permanently holding a significant amount of the government debt on their balance sheets. But the central banks are greatly overestimating their ability to reduce their balance sheets to what they were before the Great Financial Crisis. In fact, they will have to become part and parcel of absorbing, and perhaps increasing, a steady supply of government bonds by turning them effectively into consols so that the government can issue and reissue them for the central bank to keep absorbing.
Without that, I think the challenges that Charles has laid out will become a lot harder. In some senses, the fact that we went into quantitative easing in the Great Financial Crisis has softened things up a little bit and made the path a little bit easier for debt to be dealt with. But it has also made it that much more likely that debt will be issued that way going forward.
Charles and Manoj, thanks for coming on the podcast.
Goodhart: Thank you.
Pradhan: Thanks for having us. It was a pleasure.
James Pethokoukis is the Dewitt Wallace Fellow at the American Enterprise Institute, where he writes and edits the AEIdeas blog and hosts a weekly podcast, “Political Economy with James Pethokoukis.” Charles Goodhart is a financial markets professor emeritus at the London School of Economics. Manoj Pradhan is the founder and chief economist of the independent macroeconomic research firm Talking Heads Macro.
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