Paul Diggle: Hello and welcome to macro bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.

Luke Bartholomew: And I'm Luke Bartholomew, Senior Economist at abrdn.

Paul Diggle: And we're recording this episode during an exceptionally busy week for some of the world's major central banks. The Bank of Japan has just announced the end of negative interest rates, after we are recording this, but before you're likely to be listening, the US Fed and the Bank of England among others would have all met. Markets are watching closely the Fed dot plot and what central banks say about the difficult last mile of inflation. But on the episode today, we want to take a bit of a step back from those immediate central bank decisions and take a longer-term view of the history and the future of the global inflation regime. And ask in particular, whether central banks and indeed financial markets will be navigating a potential step change upwards in inflation volatility.

Luke Bartholomew: Because the important point I think, that we want to make today is that regimes are a key feature of the inflation process. Economic history is characterized by these persistent periods of inflation behaving in a particular way, and that these regimes are based on the kind of shocks that the economy is facing at that time and the institutional order in which those shocks are being adapted by the economy. And it seems that we could be shifting into a new world in that sense. But to get a flavor of that, it's probably helpful to tell a bit of a story as to how we got to where we are today in terms of our current inflation regime.

And perhaps the place to start that is the 1970s, which was famously a period of high and volatile inflation - that was the inflation regime at that point. And what was going on then was that there were these significant energy price shocks and other inflationary shocks hitting the economy. So that was a key feature of the shock environment, but also, institutionally speaking, the economy seemed to be set up in a way that exacerbated inflation shocks. And then in the 1970s, at the beginning of the decade, Bretton Woods was abandoned. The system of fixed exchange rates that many developed market economies were part of and in abandoning Bretton Woods that removed a nominal anchor, something pinning down the value of currencies and inflation. And moreover, central banks seemed ill-equipped to deal with the kind of inflation shocks they were faced with partly, they weren't particularly independent from governments, they didn't seem well placed to make the kind of trade offs in setting policy given the political pressure that they faced. And moreover, perhaps they had a somewhat faulty understanding of the economy in terms of setting policy in the right way and getting a grip on inflation expectations such that they could handle the kind of shocks that were hitting the economy so much in the 1970s.

Paul Diggle: And then, and then Paul Volcker enters the scene, Luke.

Luke Bartholomew: At least in the US, yeah, that's right. So Paul Volcker becomes Chair of the Fed in 1979, with a clear mandate to bring inflation back under control. And he's armed with a particular understanding of the inflation process, sometimes called monetarism. And this idea that the central bank can indeed get a grip on inflation and can control it, as long as it controls the money supply. And that's what he set about doing with more or less success in terms of the money supply, but certainly was able to bring down inflation via it must be said a very painful period for the economy, a large recession, but that was crucial in bringing inflation expectations back under control and establishing the idea that central banks were able to control inflation and willing to pay the price to do so. And that ushered in this period after that, the so-called ‘Great Moderation’.

Paul Diggle: Yeah, so then our story next goes to the mid-1980s up until at least 2007. This period of the Great Moderation in which not only was the level of inflation generally low, but also the volatility of inflation was well contained, hence, Great Moderation. I think a big part of that regime was that the right institutional architecture and framework in terms of monetary policy was in place. So central bankers had learned from the experience under Volcker, they'd learned from also evolving economic theory as well as practice so this was the period in which new Keynesianism, the importance of inflation expectations was all integrated into the practice of central banking. The period saw an increasing number of central banks becoming independent. The start of formal inflation targeting that most famously started in New Zealand. It also saw, of course, that the formation of the European Central Bank modeled on the inflation-fighting mindset of the Bundesbank.

Luke Bartholomew: Well, that is the institutional architecture, but perhaps Paul maybe central banks also got a bit lucky given the shock environment.

Paul Diggle: Yeah, so I think the Great Moderation was also a function of the global demand and supply environment. And they got lucky in that regard. So, it was a fairly stable global supply environment. That is to say, the ability of the global economy to supply goods and services was only stably improving. And the specific examples of that are things like the fall of the Iron Curtain in Europe, China opening up to the world economy and joining the World Trade Organization in 2001. It was the period of hyper-globalization. Think the shipping container inventory management. It was the era of the gains from the IT revolution really being reflected in rising productivity growth. It was the formation of the Eurozone and free trade within that block. And in many ways, there was a geopolitical counterpart to what economists called the Great Moderation in what historians called the ‘end of history’ as Francis Fukuyama famously, but perhaps too soon, but also, I think he's often kind of oversimplified in his thesis, but declared the end of history. And to the extent there were random shocks hitting economies, affecting inflation, they primarily came on the demand side, they affected the economy's ability to demand goods and services, rather than its ability to supply goods and services.

Luke Bartholomew: And why a demand shock driven environment is so important from a market perspective is that those are the kinds of shocks that create a negative correlation between bonds and equities so they move in opposite directions. And so shocks that push growth and inflation in the same direction, create this kind of correlation structure, because you know, when negative growth shocks are disinflationary, positive growth shocks are inflationary. And so that when you get a negative growth shock, that tends to push bonds up in price, interest rates down, and equities lower in price. So that when you get this negative growth environment it hurts your stock portfolio, but good news is that the bond part of your portfolio tends to be performing better. So you get that nice diversification. And so, portfolio construction tended to be built around this idea - famously that you'd have a 60-40 portfolio - 60% equities, 40% bonds - and those bonds would be there to protect you in that environment where your equities performed less well. But of course, the key point is that that was contingent on the particular economic environment at the time - that it was this demand shock-driven environment and that the correlation structure flowed only from that.

Paul Diggle: And do we think that period was ever sustainable - the Great Moderation?

Luke Bartholomew: And so famously it ended with the financial crisis, right? So that kind of huge shock definitely disrupted that process. But maybe there's an interesting question about whether in a sense, it contained the seeds of its own destruction. I guess there are several ways that you could make that case. So there's this argument, sometimes called the ‘Minsky Hypothesis’, or the financial instability hypothesis, and the idea there to put it sloganistically, is that stability breeds instability, that perhaps people are more inclined to take risk, to build up their leverage, in an environment of stability, perhaps regulation is more likely to be relaxed in that kind of environment. And that's precisely the kind of environment high risk- taking low regulation that then creates the kind of thing like the financial crisis. So that's one way in which it might have contained the seeds of its own destruction - that the stability was destabilizing. But then also the emphasis on monetary policy through this period as the key stabilization tool meant that fiscal policy was regulated, and sort of forgotten about as a tool to help influence the economy. And that stored up problems around the effective lower bound in interest rates. So, this is the idea that interest rates can only be pushed so low. And it's quite possible that you can get a kind of shock that would Frequire interest rates to be extremely negative. But you just can't set interest rates that low. Now, how you might respond to that, therefore, is to use fiscal policy as a complement to monetary policy. But if fiscal policy has sort of been forgotten about that kind of policy response becomes harder. And then finally, there's a sense in which a lot of the ideological underpinnings of this period – was the importance of independent central banks that were really serious about keeping inflation under control. And so that meant there was perhaps more caution about really radical policy measures that could have been taken after the global financial crisis to try and boost inflation. And so once that kind of shock came along, central bankers were less well prepared, the institutional order was less well set up to deal with that shock, because A interest rates were perhaps bound by the effective lower bound and B because there just wasn't the desire to do anything particularly radical.

Paul Diggle: Yes, the next stage in our story then of inflation regimes is the global financial crisis comes along, disrupts and ends the Great Moderation and then ushers in an era of what economists call ‘secular stagnation’ or the era of zero lower bound or sometimes negative interest rates. And the struggle really becomes one of raising inflation up to target. Central banks are constantly trying to push upwards on inflation that is too low, rather than pushing down on inflation (the historical challenge) and in doing so they're always trying to take interest rates to and indeed through zero in that attempt, then engaging the balance sheet doing quantitative easing to try and add additional stimulus to the economy. And in some ways, this low inflation is a symptom of the weak aggregate demand environment. But in a deeper sense, it was a source of liquidity trap. The central bank was unable to lower the real interest rate enough to stimulate demand. And in doing so that caused inflation to fall further, which then put additional downward pressure on real rates and put the equilibrium real interest rate further out of reach. And this is a world that Larry Summers would have seen, when he reintroduced the term secular stagnation to describe that sort of environment. It was a world of, of low numbers, persistently low inflation, low growth, low interest rates. And then it wasn't helped, or layering on top of that, was that productivity growth and innovation seemed to have stalled. Now partly that was endogenous to the weak demand environment, perhaps constraining investment, but also if you're someone like Bob Gordon, an economist who wrote this book called ‘The Rise and Fall of American Growth’, then weak productivity growth was also down to having exhausted the gains from the computer revolution and, over an even deeper history, having plucked the low hanging fruit of multiple industrial revolutions. Now, we've spoken on the podcast before about whether AI is a new general-purpose technology that will fuel the next industrial revolution, the next wave of productivity growth, which has certainly been stronger of late in the US. It's a live theme in financial markets, but certainly, during secular stagnation, there was a noticeable dearth of productivity growth.

Luke Bartholomew: And of course, this period of secular stagnation was a formative period for many of today's central bankers, policymakers, economists, dare I say ourselves included Paul?

Paul Diggle: Yes, indeed. And the lesson, I think that that was generally taken away from that period was, maybe the central bank can't set the price level after all. So, the lesson from Volker was that the central bank can set the price level, they can bring inflation down. The problem is you have to impose economic pain to do so and there might be a difficult last mile to bringing inflation down. But perhaps, actually, the central bank can't raise inflation when the problem is that it's too low. Crudely put, it may have embedded a structurally dovish bias in central bank thinking that arguably ill-equipped them for the sort of dynamics that then occur next in our story during and coming out of the pandemic.

Luke Bartholomew: And of course, what the pandemic is an example of is a huge negative supply shock and probably therefore, an example of the kind of shocks that we think that the economy is more likely to be facing into the future that we're heading into, a world of persistently more supply side shocks. And this is probably a world in which we think that inflation on average could be higher than 2%. That is not to say that we get stuck at 3 or 4%, it's just that we would be persistently approaching 2% from above, rather than below. And so the mean value of inflation becomes higher than 2% even if the mode, the most frequently observed inflation value, is 2%. And this is a world in which zero lower bound probably becomes a less pressing concern, even if the equilibrium interest rates are still reasonably low. So, it is a very different kind of world to the one in which central bankers, policymakers had their formative experiences.

Paul Diggle: And I think crucially, it's a world in which the volatility of inflation is now structurally higher. And that's perhaps an even more important consequence than that the average level, even if not the mode, of inflation is higher. So why might inflation be structurally more volatile? Well, if you are primarily experiencing supply shocks, and negative supply shocks at that, you're going to be putting upward pressure on inflation during the shocks. And it's not hard to motivate where more common negative supply shocks could come from. I mean, first and foremost from the geopolitical environment. So we appear to be in an era in which global supply chains are decoupling from one another, where globalization is at least slowing if not reversing. And we've done work trying to measure globalization, and it certainly seems to have taken a significant downshift over the past few decades. Supply chains are being built for resilience, rather than for fully exploiting the gains from trade. Now, arguably trading efficiency for resilience something that China is trying to do in building domestic semiconductor sectors - likewise, the US. Arguably in the long term that makes you more resilient to negative supply shocks that’s precisely the purpose of doing it, but the transition, the shifting and remaking of global supply chains during that process is a negative supply shock with inflationary consequences. Of course, the global supply of key resources is increasingly concentrated in geopolitically volatile parts of the world, think Russia and European energy supply, but also in a forward-looking basis, China and rare earth metals crucial to the energy transition, Taiwan and the supply of leading-edge semiconductors, so you know, something we've talked about on previous episodes. There are an increasing number of choke points in global trading environments. I think it was Luke a Victorian era British admiral who said ‘five keys lock up the world, Singapore, the Cape, Suez, Gibraltar and Dover - and today, we might add to that list the likes of the Taiwanese straits, the South China Sea, the Strait of Hormuz, the Red Sea, and Suez is something we're seeing play out right now, as well as Panama, the Cape, and other key choke points. The point is that a lot of those are located in potentially geopolitically volatile parts of the world. And perhaps the domestic counterpart to increased global geopolitical volatility is that domestic politics over the past decade or so has been shifting in a populist and less democratic direction, which means that there is less patient supply side reform. Brexit is a possible example of a negative supply shock arising from shifting domestic political preferences. But it's not just on the political front where I think you can motivate more negative supply shocks. It's also on climate. A warming world, a more volatile world in terms of weather, El Nino affecting food production, drought, affecting food production, the level of certain important rivers that are crucial to global trade, the Rhine in Germany, the Panama in Central America, and the Yangtze and China. We've seen recent examples of all of these being affected by drought and that disrupting global trade and in some cases, putting upward pressure on inflation. And then the climate transition in general making fossil fuel more expensive. People talk about green inflation. And then perhaps a final motivating factor, which 5 to 10 years ago would have seemed like a bit of a kind of a kook for mentioning but in now obviously very serious is the risk of future pandemics.

Luke Bartholomew: So why does all of this matter this world of more negative supply shocks, I think there are probably several important implications of this first, that it makes the job of central bankers that much more difficult remembering that negative supply shocks are just those kinds of shocks that push inflation up and growth down at the same time. So policymakers are facing a trade off in terms of how they deal with that kind of shock. And maybe that makes policy harder to predict, because we don't know how policymakers will make that kind of trade off, how they'll think about the loss function. And it's also a world in which perhaps political interference becomes more of a thing politicians take more notice about the way in which central bankers are navigating that trade-off. It is a deeply political question, at some level, how much you should be prioritizing, bringing inflation down versus supporting the economy when unemployment is high.

And then relatedly, inflation expectations become less well anchored if the mean of inflation is that much higher, and there is more uncertainty around how central banks will set policy, or perhaps that pushes up inflation expectations, and there's sort of a self-fulfilling logic there, in terms of inflation, on average, perhaps being a bit higher and the difficulty of central banks keeping inflation expectations under control. Also, from a market perspective, it makes diversification harder because the equity bond correlation becomes positive at times. So, remembering that the Great Moderation was so great for portfolio construction, a 60-40 bond portfolio, because of it being one characterized by demand shocks, well, with supply shocks, you get shocks that push growth and inflation in opposite directions. And therefore, environments where bonds performed poorly is also one in which stocks tend to perform poorly as well. So, getting diversification becomes that much more difficult. Building a portfolio that's robust to different shocks becomes harder, and perhaps a broader range of asset classes need to be brought in to make that kind of diversification.

And then finally, it's a topic we've touched on before, and it's a little bit esoteric, but it's this idea that the term premia- the extra compensation that you get as a bond investor above the expectation of interest rates, that needs to move higher in a world of more supply shocks. Because with that correlation structure with falling diversification benefits of bonds, maybe you need to be paid a little bit more to be prepared to actually hold the bond in the first place, which is another way of saying that yields need to be higher. So there are very important implications for the way in which monetary policy will be set, the potential for political interference around policy and the appropriate way to construct policy and asset pricing that follows from the fact that we do seem to be moving to a somewhat different inflation regime than the one that we've been in previously.

So that is all we have time for on Macro Bytes this week. As ever, please do like and subscribe to us wherever it is that you prefer to get your podcasts. And all that remains is for me to thank you all for listening. So thanks very much and speak again soon.

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer investment, recommendation, or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provides no guarantee of future results.