Political economy of inflation across advanced economies

The first of this two-part data journalism series looked at various aspects of inflation in advanced countries and underlined the differences between inflation in the US and Euro area economies. This part will look at the political economy around inflation in this region. Whether or not an aggressive hike in interest rates will control inflation has become a major topic of debate in advanced economies and this is not a debate limited to just economists at the moment. Here are three charts which explain the major factors shaping this debate.

The curious case of falling consumer sentiment but rising consumer spending in US

In a sharp downward revision from its April forecast of 3.7%, the IMF now expects the US economy to grow at 2.9% in 2022. One of the major reasons for this downward revision was the expectation that US Federal Reserve will hike interest rates going forward. While the IMF expects that the US will "narrowly avoid a recession", many private sectors forecasts see a recession as a certainty. US consumer confidence data, which dipped to a 16-month low in June as inflationary worries left "consumers to anticipate that the economy would slow significantly or even slide into recession in the second half of the year", underscores such predictions.

What is surprising, however, is the fact that US labour markets do not seem to be showing any signs of distress yet. Data from the Bureau of Labour Statistics (BLS) shows that the monthly unemployment rate was 3.6% in May, staying constant for the third consecutive time. Average hourly earnings in the private sector grew by 5.24% in May over the last year and is 14.7% higher than the pre-pandemic levels. While the earnings growth in May is 23 basis points – one basis point is one hundredth of a percentage point – lower than the April reading, it is still far higher than the average yearly growth of 3.3% in 2019.

But inflation seems to be chipping at the political capital of advanced economy governments

The robustness in macroeconomic indicators on unemployment and wages notwithstanding, governments across advanced economies are having to firefight inflation. Joe Biden's government is calling for a three-month tax holiday on petroleum products, the UK government is having to deal with labour strikes in various sectors demanding higher wages and in France, President Emmanuel Macron lost control of the National Assembly in legislative elections on 19 June.

"Inflation has emerged as a major political challenge for President Biden and congressional Democrats. Only 31 percent of Americans said they approved of Mr. Biden's approach to inflation; support was muted even among Democrats, only 58 percent of whom said they approved of Mr. Biden's approach, and only 15 percent of them strongly", A New York Times report said . The growing impatience with inflation is the biggest factor which could sway the political mood on inflation despite many credible economists, such as Joseph Stieglitz, arguing that raising interest rates is not going to be help fix inflation at the current moment.

And central banks might be overzealous to tame inflation having had to eat humble pie

Because most advanced economies adhere to the inflation targeting framework, inflation management is a responsibility which rests with the monetary policy arm and therefore the central banks. On this front, central banks in most advanced economies, the US Federal Reserve included, failed to see the inflation problem becoming so serious.

In fact, almost a year ago, Federal Reserve Chairman Jerome Powell said, "Fed will remain cautious in any eventual decision to raise interest rates as it tries to nurse the economy to full employment," adding that he wanted "to avoid chasing "transitory" inflation and potentially discouraging job growth in the process," stated a Reuters article on 28 August .

Powell has had to make a turn of stance from complacence to quasi-helplessness. "The events of the last few months have raised the degree of difficulty. There's a much bigger chance now that it'll (inflation will) depend on factors that we don't control. Fluctuations and spikes in commodity prices could wind up taking that option out of our hands," he said in a Wall Street Journal article on June 15.

The only question is how far will central banks across advanced economies go on the path of rapid monetary tightening to restore their credibility at the moment. The US Federal Reserve undertook the largest interest rate increase of 75 bps since 1994, thereby raising the Fed's benchmark federal-funds rate to a range of 1.5% - 1.75% in its latest meeting on 15 June. The European Central Bank confirmed its intention to deliver the first hike in interest rate since 2011 by 25 bps, from -0.5%, next month, reported Reuters on  9 June.

While aggressive monetary tightening might repair the credibility of central banks in financial circles, it does not have popular approval. "Survey respondents were equally critical of the approach taken by the Federal Reserve, which has begun aggressively raising interest rates in an effort to bring down inflation. Only 30 percent of Americans said they approved of the Fed's handling of the issue", the New York Times report cited earlier said.