Ricardo Reis on Inflation Risks

Video & Timestamps

On Thursday, February 17, Ricardo Reis joined Markus’ Academy for a lecture on Inflation Risks. Reis is the A.W. Phillips Professor of Economics at the London School of Economics.

Watch the full presentation below. You can watch all Markus’ Academy webinars on the Markus’ Academy YouTube channel.

Timestamps:
[0:00] Introductory remarks

[9:32] Last 20 years, successful inflation regime

[14:55] Pandemic initial response, and challenges of 2021

[27:55] New U.S. inflation regime?

[48:37] Possibility of Eurozone deflation trap

[55:48] Benefits of the inflation regime and price stability

Executive Summary

• [0:00] Introductory remarks: inflation expectations involve wage bargaining and price setting.  Households, firms, and bond traders have (possibly) different inflation expectations. Household’s inflation expectations are primarily driven by salient prices like food and energy. Inflation during the pandemic exhibited a whipsaw pattern, dropping at the beginning and bouncing back. Expectations inferred from gov. bond prices (inflation indexed or not) can be distorted through QE activities of central banks. Green inflation might drive up inflation numbers further, esp. as energy prices rise. It is paramount to keep inflation anchored for monetary policy to stay effective.

• [9:32] The last 20 years have been a very successful inflation controlling monetary regime. Data over the last 300 years shows that in the U.S. and U.K., inflation was as close as it has been to the target; this is because of a combination of the three pillars of central bank independence, inflation targeting, and the primacy of the short-term interest rate set in transparent and predictable ways. The last decade has seen periods of low real interest rates, strongly anchored inflation expectations, a shift to real activity, and financial dominance.

• [14:55] The initial response to the pandemic was very successful, but the upside risk came in late 2021, and now we must orchestrate a soft landing. During 2020, we used all of the same tactics of the last decade, but in 2021, we saw that the expansionary policy may have been too much, too long. The Fed embraced a “no pasa nada” theory through focusing on the good signs, but missing out on some possible challenges; could have been due to groupthink, using old tactics, financial dominance, polarization, political imbalances, or bad luck. Still debates over transitory vs. persistent. 

• [27:55] Great risk of a new inflation regime in the U.S., many different possibilities. Most likely that there will be a soft landing, but there are a few other possibilities, including a recession in 2023-’24, or in the worst case, an inflation disaster caused by a panic. By looking at the five-year five-year expected inflation, we can see beliefs without any of the transitory factors weighing in. Using inflation swap options one can back out the whole inflation distribution (not only the average expectation), but it is important to correct for certain factors. 

• [48:37] Possibility of a deflation trap in the Euro area. Very different from the U.S., where QE was implemented because of how strong the shift in expectations was away from a high inflation scenario. Pandemic showed a smaller upward shift in expectations, but still smaller than the U.S. There is still lingering belief that there will be deflation, and that belief has gone up significantly since the start of the pandemic, but fears exist of a similar situation to Japan in 2001, where expectations were anchored between 0-1% for two decades. Part of this is due to ECB institutional weakness, perhaps because of a lack of a European safe asset (SBBS/ESBies). 
• [55:48] Benefits of keeping the inflation regime and price stability. Public debt has been growing over the recent decades, making monetary policy more challenging. Inflation helps to inflate away the debt only temporarily, and debt sustainability requires more independent central banks and price stability.