- Several factors, including worker shortages, rising wages, supply chain disruption and fossil fuel policies, led to the current inflation crisis in the U.S. But another element, interest rate hikes by the Federal Reserve, has an even more significant effect on inflation.
- Economist William White says central banks are “ultimately responsible” (most of the time) for periods of inflation. He argues that banks’ failure to recognize supply-side shocks is a cause of the current economic crisis.
- Bill joins co-host Alan Dunne for a conversation about monetary policy, the root causes of inflation now (and historically) and what worries him about today’s economic circumstances.
It’s difficult to disentangle the various factors that led to the current inflation crisis in the U.S., but if anyone can do it, it’s William White.
Bill is a veteran economist, policy advisor and policymaker who accurately predicted the financial crisis of 2007–2010 before the subprime meltdown. He was head of the Monetary and Economics Department at the Bank for International Settlements (the Swiss-based “bank of central banks”) in the 1990s and the 2000s, where he oversaw the publication of the BIS annual report.
Famously, Bill confronted Alan Greenspan at the Kansas City Fed's 2003 annual meeting in Jackson Hole, Wyoming, about the then- Fed chairman’s view that central bankers cannot effectively slow the causes of asset bubbles. (Talk about being “in the room where it happened”!)
Spoiler alert: Greenspan’s perspective on asset bubbles was just one of the failed policies that Bill argued against over the years. In fact, Spiegel International called him the “Man Nobody Wanted to Hear” in 2009.
As part of “Global Macro,” a series of Top Traders Unplugged episodes that focus on markets and investing from a global macro perspective, Bill joins co-host Alan Dunne for a discussion about monetary policy and how it can negatively impact the economy. They talk about the causes of the current rebound in inflation, specifically how central banks can improve (or worsen) economic crises and much more.
Here are a few takeaways from their wide-ranging conversation.
Inflation: What’s to blame?
Alan asks Bill which he thinks has spiked inflation most: the Fed’s prolonged period of quantitative easing, recent supply-side challenges or the fiscal stimulus of the last few years?
“The question is: What’s caused the rebound in inflation?” Bill replies. “I think it is very complicated. There are elements on the demand side and on the supply side, but as Milton Friedman once famously said, ‘Inflation is always an everywhere monetary phenomenon.’”
Bill says that in the long run, Friedman’s axiom holds true — “in the sense that central banks are ultimately responsible for inflation.”
That’s why he thinks central banks’ decisions (like raising interest rates) bear a significant amount of the blame now.
“You just have to look at what they did, which was extraordinary, even by the standards of 2008,” he explains.
For example, between the end of 2019 and May 2022, M3 (“broad money,” which includes currency, certain kinds of deposits, money market fund shares/units and certain debt securities), grew 42% in the U.S., 22% in the U.K. and 21% in the eurozone.
Numbers like that suggest that “somehow this was too much of a good thing,” Bill adds. “I worry that what they have been doing could well lead to inflation getting out of control.”
Blame the central banks?
When he looks at the central banks' behavior over the last 20 to 30 years, “it seems they have fundamentally misunderstood the importance of supply-side shocks,” says Bill. “I contend … and the BIS has long contended, that the deflationary pressures we have faced since the turn of the millennium owe as much to positive supply-side factors as anything else.”
Those factors include China, India and Eastern Europe adding billions of new workers to the tradable part of the global economy, he adds. Plus, demographics in Western countries (like baby boomers aging out of the workforce) are favorable, creating supply-side shocks that drive prices down. Failing to recognize that, central banks “leaned against it because they felt it was dangerous,” Bill adds. “I thought it was not. They’ve created many of the problems we currently have.”
Those banks made the same kind of mistakes during the pandemic — by suggesting that supply-side effects would be less consequential than demand-side and negative effects. The supply-side effects proved to be much larger and longer-lasting than the banks expected. The assertion in the U.S. and elsewhere that the supply shocks would be transitory “allowed momentum to build up on this sort of wage/price side that is now going to be harder to resist than it was previously,” says Bill.
Watch for (and worry about) these trends
Bill also worries that the central banks are “underestimating both the diversity and the magnitude of the supply-side shocks still to come,” he says. He runs through a list of inflationary characteristics and contributing forces we should worry about, too:
- Pre-pandemic resource misallocations: Misallocated resources have already had negative effects on supply potential — and “if the tough times come and bankruptcies rise, we’ll start to see the implications of those misallocations,” says Bill. “I think there are forces there that will cause prices to go up.”
- Post-pandemic forces: China’s “Zero COVID” policy contributed to the supply chain crisis. Until we can depend on reliable supply chains, the cost of imported goods will remain in flux.
- Long COVID: This has “reduced the [labor force participation] rate in both the U.S. and the U.K., as far as I know,” says Bill.
- Aging populations: Charles Goodhart and Manoj Pradhan wrote a book about this issue: Demographic trends (such as a massive supply of labor in China) once pushed prices down, but now aging populations “pushes everything in the opposite direction,” Bill notes.
- Climate change: “Whether you look at adaptation or mitigation, this is going to be very costly and push prices up,” says Bill. “Certainly, it’s going to cause big resource problems, in the sense that demand might be greater than reduced supply.”
- Commodity prices: Some economists say the supercycle [of growth] is behind us, but Bill disagrees. “We’re moving away from fossil fuels into a new era that’s going to be characterized by heavy dependence on metals,” he says. “Think about all of the stuff that needs to be done to green-electrify the economy. Copper inventories are already very low. We’ve got a massive increase in demand coming down the road.”
- Deglobalization of business: We’re still feeling the impact of supply shocks associated with Russia’s war in Ukraine. Although Russia’s export market is tiny compared to China — and isn’t integrated into global supply chains the way China’s is — the deglobalization effects Russia has caused are concerning. ”Imagine that in spades with China,” Bill says. “There are a lot of these things coming down the road that the central banks should be more cognizant of and more worried about. Failing to see the supply-side stuff has been a recurring problem for decades.”
The ‘70s are back… or not?
Given what Bill says about supply shocks, Alan asks him if we simply must accept lower growth going forward, or whether there’s a way to calibrate policy in an environment of more constrained aggregate supply.
The difference between today’s inflation and the inflation of the 1970s is that “there was more of a tendency in the ‘70s for the supply shocks to be self-equilibrating,” Bill says. “If you’re paying more for energy in the U.S. … you have less money to pay for something else.”
The inflation of yesteryear was essentially stagflationary — growth slowed while prices rose.
“In a certain way you didn’t have to lean against it as much because the system itself was tending to equilibrate at a lower level of inflation and growth,” says Bill, who adds that today’s supply-side shocks “really ought to invite more investment, not less.”
Moving away from fossil fuels to renewables requires significant investments, which increases aggregate demand.
Demographics, too, need to be addressed with financial expenditures. An aging workforce means that “all of a sudden, companies can’t get workers. What are they going to do?” Bill asks. “In part … they are going to raise investment in order to replace higher-priced workers with real capital.”
Bill predicts companies will do the same thing with respect to climate change.
“We’re going to need to do a lot of things very differently,” he adds.
‘Inflate it away’ or honor debts?
Several economists, like Joe Gagnon from the Peterson Institute and Olivier Blanchard, recently argued in favor of raising the inflation target.
“There’s no question that a higher inflation target is part of the way out,” says Bill. “It’s not impossible that the central banks will say they’re going back to 2% but in reality will pursue qualities that are not so tight and might be more consistent with 4%.”
That’s because he thinks the banks will recognize that mitigating a global debt problem — “which is the kind of problem we have,” Bill says — “is to just inflate it away.”
However, if we consider “intergenerational accounting stuff,” factoring in “off-balance-sheet promises as well as the contractual obligations of governments,” virtually all Western countries are likely to experience a massive budget shortfall, says Bill, citing expected tax revenues and government entitlement obligations.
Estimates from think tanks like the Cato Institute indicate that this phenomenon is happening already: “Governments have, over the years, made commitments they will not be able to honor given current tax levels,” Bill adds.
We couldn’t let Bill go without asking him a question for up-and-coming investors and students (college or armchair) of macroeconomics: What books or other sources has he found influential over the years?
He admits to keeping “a big file on economic theory about a foot and a half high” and that it’s helpful to think about the world in terms of today’s “complex adaptive stuff.”
He recommends the OECD’s “New Approaches to Economic Challenges,” a collection of essays by “heavy hitters” about how the financial system operates, which includes a chapter he wrote called “Simple Policy Lessons from Embracing ‘Complexity’.”
Bill says that while the economy is complex and adaptive, some essential yet simple lessons for policymakers may come from just accepting that “systems always break down according to a power law,” he says. “The lesson is to be prepared.”
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.