Arguably the most important current macroeconomic debate is about the persistence of inflation. How persistent will it be? What should be done to address this persistent inflation?
The challenge facing policy makers in governments and central banks is that of engineering a soft landing and bringing inflation under control without engendering a recession. The critical part is bringing inflation under control. Economic orthodoxy has become wedded to the faith that inflation is under control when it's below 2%, and therefore as long as it stays higher than 2% inflation remains a problem. Policy makers are forced into accepting this orthodoxy by both the economists and monetary policy experts advising them as well as the market expectations of what constitutes stable inflation.
There's a problem with this orthodoxy. As has now been widely exposed, there's nothing objective or sacrosanct about the 2% target. It was, for all practical purposes, arbitrarily pulled out of the hat by a group of experts based on the circumstances prevailing then. If the same set of people sat down today and were to fix a target, they are more likely to have fixed 4% (or some such higher target).
Further, the 2% may have been fine for the near four-decade long Age of Moderation since the early eighties. This period coincided with the emergence of several factors that contributed to keeping inflation and interest rates down. They include globalisation of trade and finance achieved through economic and financial opening up of the world economy and the emergence of globalised value chains in goods and services aided by technological advances; the emergence of China (in particular) as the factory of the world supplying goods at cheap prices; and favourable demographics and other factors contributing to a global savings glut. The tailwinds from these forces were enough to create globally integrated markets for labour, capital, goods and services, thereby lowering the cost of production significantly and putting downward pressure on prices.
Now that all these tailwinds have disappeared and some have turned to become headwinds, it's only natural that inflationary pressures mount and interest rates rise from their previous normal. At the least, a return to the low inflation and ultra-low interest rates of the last decade and more will be almost impossible. Therefore, there are strong reasons to argue in favour of raising the inflation threshold to say, 4%. The IMF endorsed it as early as 2010,
A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This benefit would come at minimal cost, because four percent inflation does not harm an economy significantly.
Olivier Blanchard, first as the IMF Chief Economist and subsequently, has been a consistent advocate. The likes of Kenneth Rogoff have earlier advocated a much higher target of 6% for the US, mainly to inflate away some of the accumulated pile of public debt. There's the precedent of post-war debt example of inflating away public debts in many developed countries. This is another strong case made out for a higher inflation target.
However, for policy makers to disown the orthodoxy and adopt a higher inflation target is not easy. While raising the inflation target to 4% citing the aforementioned logic might have stood a chance of being accepted in good times (though it's unlikely that any economist would have had the courage, leave aside foresight and wisdom, to break-away from entrenched academic faith and support such choices when things are going well), it becomes stigmatised in bad times and will be seen as a panic stricken response. It's similar to imposing capital controls in response to capital flight as against doing the same when times are good. The market reactions to the same set of actions will be very different.
This would go against the advice of experts and the prevailing technical expertise-based narrative. It's widely perceived that it will not be taken kindly by the markets and will result in market convulsion that would destabilise the economy. This risk is also perceived as being higher given the several fault lines in an economy that had become addicted to low interest rates for a long period of time. There's a self-reinforcing dynamic to this - experts spout the orthodoxy, markets internalise this belief, policy makers shy away from making choices that go against the experts, market expectations get reinforced, the beliefs get entrenched, and on it goes.
In the circumstances, a prudent strategy may be to let things be. Policy makers should be seen to be doing everything possible to bring down inflation, but stopping short of triggering a recession. This is a fine line that nobody knows and would therefore necessarily involve actions that will be perceived by at least some as being half-hearted and muddled. That may well be the requirement.
Instead of moving decisively to tighten and stop inflation (with the risk of a hard landing and recession) or moving equally decisively in the other direction to raise the inflation target to 4% (with the risk of a market backlash and recession), the circumstances demand that the system find its way to the soft-hard landing and higher inflation target. The path dependency (to reach 4% or some other target and the soft-hard landing) is important. The system has to collectively (the market perception in particular) undergo the tortuous struggle of trying and exhausting all options of achieving a soft landing before it becomes ready to accept the new inflation target. The struggle is the solution.
This is a teachable instance in dealing with wicked problems, or those that are so complex and beset with incomplete, changing and contradictory requirements, as to have no clearly defined solutions. Inflation today and raising inflation target are wicked problems.
The solutions to wicked problems can be considered as being path dependent. Their resolution depends on the nature of the collective struggles and its accumulated set experiences (especially the difficult and bitter experiences). Therefore the solution, to the extent it can be called a solution, is the struggle. The struggle generates its dynamic, creates the conditions, clears the fog of uncertainty, and shows the path for bringing down inflation. It's apt to recollect this quote attributed to E L Doctrow in some other context,
'Writing is like driving at night in the fog. You can only see as far as your headlights, but you can make the whole trip that way.'
The struggle to address wicked problems should embrace this strategy. The challenge then is to steer the struggle by intervening at opportune moments. It's not to avoid the struggle, but to minimise the pain from the struggle by steering the course.
This framework is useful to explain several issues in public policy and international development. Consider the issue of aid and international development. It's common to find external experts suggesting innovative solutions to deep-rooted social problems like poverty alleviation, poor student learning outcomes, improving public health etc, in low income countries and donors and philanthropic organisations supporting those innovations.
Such transplanted and reductive prescriptions are a serious obstacle to sustainable development. They prevent these countries and their societies from undergoing the difficult struggles to face up to the reality of their situations and the enormity of the challenges ahead, make conscious and collective decisions, craft solutions appropriate for their contexts, prioritise the allocation of scarce resources, create the systems required to implement their decisions, and generally feel the ownership of the solutions and the need to generate value for money from these expenditures.
Sometimes we need to accept that there are no clear solutions. And the pathway to a solution is to embrace the collective struggle. This can be difficult, even profoundly unsettling, for human mind to accept. But that may be the reality.
Update 1 (07.07.2023)
Inflation status across the world
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