During a 30-year tenure at Morgan Stanley, Stephen Roach served as the firm’s Chief Economist and as the Chairman of Morgan Stanley Asia. Now a faculty member at Yale, Roach is an influential commentator on topics such as China, globalization, and trade, frequently appearing on CNBC and writing for outlets including the Wall Street Journal and Financial Times.
The causes of inflation are being debated, but before we get into those, I want to ask about how we know that inflation is even occurring. What metrics do you find most useful for gauging inflation?
Primarily, we use the Consumer Price Index put out by the Bureau of Labor Statistics. We then use a comparable index put out by the Commerce Department called the consumption price deflator. Sometimes, we take out food and energy to get a clean read on the non-volatile factors of inflation.
There’s also an ancillary index put out by the Bureau of Labor Statistics, called the Producer Price Index, that looks mainly at price pressures bearing down on producers at different stages of the production process. We look at commodity prices, metals, energy, oil. There’s a lot of anecdotal price evidence. You know, new cars, used cars, home prices, and the like.
So we’re not lacking in metrics. And the conclusion of virtually all of the ones is that in the last nine months, there’s been an appreciable acceleration in the rate of price increases. It’s now caught the attention of the Federal Reserve, which is empowered by Congress with aiming for “price stability,” defined by the Fed as an inflation rate that is closer to 2%. We’re well above that right now.
Did some economists see this upsurge in inflation coming more than others?
Well, I hate to beat my own drum, but 19 months ago, I wrote an op-ed piece in the Financial Times. The title of it was something like, “A Return to 1970s Stagflation is Only a Broken Supply Chain Away.” And, you know, the supply chain has broken for all practical purposes. We’re seeing bottlenecks and congestion all around the world.
And yet, I don’t want to give myself too much credit because while the supply chain is a big issue, I don’t think it would have been enough in-and-of-itself to cause the type of sharp surge we’re seeing. That is, I think, equally traceable to an extraordinary bounce back on the demand side of most major economies. It’s this combination of a fragile and now broken supply chain –– in the face of an explosive bounce back in post-lockdown aggregate demand –– that is really wreaking havoc on the inflation front.
So there’s been an increase in supply chain issues and an increase in aggregate demand. Are there any other pieces that are important causal factors, such as monetary and fiscal policy?
Well, what we tend to look at is the relationship between the policy of central banks –– or in our country, the Federal Reserve –– and inflation. And the Fed has been adamant, up until very recently, in its denial that this inflation problem was serious.
The fiscal authorities have also played a role. I mean, we’ve had a lot of stimulus –– understandable in many respects to deal with COVID. Now, we’ve had a large infrastructure bill enacted, and there’s a lot of debate over this nearly $2 trillion Build Back Better plan. We’re pouring a lot of fuel on a smoldering fire. History tells us that that’s something that could be consequential for inflation or for the central bank, which is charged with holding the line on inflation.
The markets don’t seem too concerned about it. But I suspect that is a little bit of wishful thinking there.
How do you expect the Federal Reserve and the Biden administration to respond to rising inflation? And equally importantly, how should they respond?
I think the Fed has pretty much telegraphed how it’s going to respond. It’s going to cut back the growth of its balance sheet. It’s been injecting about $120 billion a month into the economy –– $1.4 trillion a year –– to deal with COVID. Its balance sheet is swollen to a record level. A few months from now, what used to be $120 billion will be cut to, say, $90 to $100 billion, and then it’ll be cut successively over the next several months.
We call this tapering the balance sheet because they’re slowing the rate of growth in the balance sheet, but the Fed has not given any signal that it wants to reduce the size of the balance sheet. They just want to reduce the incremental growth over a relatively prompt period of time to zero. And then if the inflation problem continues to be viewed as serious, they would take the next step, which would be to raise their benchmark policy rate, the federal funds rate, which is zero. That would not come until much later in 2022.
They’ve got the order of this operation backward. They need interest rate increases immediately. But I don’t think the Fed is going to listen to me. I think they’ll be very cautious and very gradual in raising rates.
I’ll tell you why this worries me. The Fed is operating as if the inflation environment in the United States has been temporarily disturbed by these COVID-related gyrations. They are still clinging to the view that eventually the inflation rate is going to go back to what it was before COVID, which is slightly below 2%.
That makes sense, if, in fact, that operative view turns out to be correct and inflation does move back fairly promptly to its pre-COVID norms. But that begs the toughest question: what if that’s not correct? You can make the case that right now the inflation rate is nearing its peak. We had an October CPI that was about 6.2%, above its yearly rate. But does that mean that’s as bad as it gets, and it returns very promptly to 1.5-2%? I don’t want to make that bet.
I don’t think inflation is going to stay at the current elevated rate. But I would not be surprised, over the next few years, to see inflation run materially above what it did pre-COVID. And in that case, this normalization strategy that the Fed has got, which was designed to deal with a very low inflation rate, may not be appropriate.
If we run into another economic crisis, how severely does this inflationary environment tie the Fed’s hands?
That’s a great question. The Federal Reserve Board right now has got its major instrument, the federal funds rate, at zero. So let’s say there was another crisis immediately. They have no ammunition. As we used to say in the trade, the central bank is out of basis points. They’re not going to –– as is the case in Japan or in Europe –– move to a slightly negative policy rate. The Fed has steadfastly resisted that. So the only thing they can do, if there’s a crisis when the policy rate is zero, is to go to work and once again inject massive amounts of liquidity into the system by a sharp expansion of the balance sheet.
Zero interest rate policy, fondly known as ZIRP, is designed to address a crisis. The mistake that the Fed and other central banks make is to keep interest rates at zero long after the crisis is over. They err on the side of providing too much stimulus so they’re caught without much optionality in the event of another crisis. That’s okay if the inflation rate is really low, but it’s not okay if the inflation rate is well above the Fed’s 2% target.
This might be unfair to ask, but people like asking economists to be oracles. Do you see a risk of an economic downturn in the near- to mid-term, COVID-related or otherwise?
Shock-related, it’s impossible to tell because by definition, we don’t know when the next shock is coming. I mean, we’ve seen lots of variations on the COVID theme, with one variation following another. The operative view today –– and this could change tomorrow –– is that the Omicron variant is not as lethal as the Delta variant.
But can I predict the next crisis, the next recession? I used to get paid to do that on Wall Street. And I was never bashful about doing it. But you know, now I’m an academic at Yale. I have to be perfectly honest to you and say that that’s impossible. You can come up with a lot of possibilities. But forecasting is always about weighing the probabilities of a wide range of outcomes. Right now, there doesn’t seem to be the type of major imbalances at least in the United States that might hint at an imminent recession. But if the inflation rate kept running hotter, for longer, and the Federal Reserve finally recognized it had to move aggressively, that could certainly sow the seeds of a downturn toward the end of 2022. But the odds of that happening, I think, are low.
Inflation has also become a top political issue, leading to a lot of finger pointing. To what extent do you pin responsibility on the Biden administration versus predecessors in the Trump and Obama administrations, or on Federal Reserve officials?
I would put none of the blame on either the Trump or the Biden administration. The way I see the inflation story in the United States is pretty much the way I described it at the beginning of this conversation. The supply side was always stretched. There was very little slack that we built into these global supply chains because supply chains stood for one thing, and that was efficiency and low cost production –– taking advantage of all the cheap inputs around the world. And then on top of that layer, you had a sharp, unprecedented lockdown in aggregate demand, followed immediately by a reopening that led to a big spike. You had a real destabilizing mismatch between the aggregate supply and demand that really did not have anything to do with the politics of the moment.
Since you’re the former chairman of Morgan Stanley Asia, I also want to about international economics. What are you seeing in terms of inflation beyond the US?
It’s picked up around the world, especially in Europe, the UK. Less so interestingly enough in China, but it’s picked up a little bit there.
Why less so in China?
If we look at the state of development in the US versus China, so much of the inflation that has occurred in the US has been in a wide range of durable goods: cars, construction, appliances. The mix of the purchases of Chinese consumers is less dominated by those sharply rising durable goods as is the case in a more advanced economy like the US. The Chinese economy is growing a lot, but it’s on a per capita basis considerably poorer than the United States and barely makes the upper 50% on a per capita basis of global standards of living. So China’s buying patterns are not as adversely affected by the types of supply and demand imbalances that we are seeing here.
Is there anything else that you want to add?
I’m old enough to have worked as a professional economist during the 1970s when I started out at the Federal Reserve Board. I saw firsthand how a very sophisticated, highly professional organization like the Federal Reserve Board misdiagnosed inflation back then and fell well behind in addressing it.
In the early ‘70s, when inflation first became a problem, it followed the Arab oil embargo of late 1973. That led to a quadrupling of world oil prices. The Fed chairman at the time, a man that I worked with very closely, Arthur Burns, said, “This is transitory. It has nothing to do with monetary policy. We’re not going to react to it.”
A few months later, food inflation picked up. Burns called us into his office. He said, “I’ve studied this, and this is due to the El Nino weather patterns, which had an adverse impact on schools of fish off the coast of Peru.” These fish were, like, little anchovies that go into the production of feedstocks for cattle and pigs in America. Lacking that input, the price of beef and pork started to skyrocket. Burn said, “I’m not going to deal with that.” Because that’s not something monetary policy should operate under. And so he asked us on the staff where I was at the time to take food and energy out of the Consumer Price Index.
We protested. We said, “You can’t do that. These are things that people need, day to day.” He said, “Well, if you don’t do it, I’m gonna find somebody who will.” He sort of threatened our jobs. So we did it. We didn’t realize it but in performing that exercise, we created the first version of what is now known as the core CPI, which is a CPI excluding food and energy. But Burns didn’t stop there. There were other “temporary” disturbances that occurred in the months that followed, whether in car prices, housing, mobile homes, jewelry, you name it, one after another. And he had us take them all out. By 1995, we had taken out about 60% of the CPI, and the remainder was still going up sharply. And only then did Burns see that there was an inflation problem.
I tell you this long-winded story because you have to be really suspicious of calling a wide range of price disturbances “transitory.” That was a big mistake in the 1970s. In the current situation, there’s reason to believe that some of the disturbances are transitory, but when they spread to the extent they have, you have to err on the side that they’re going to last longer and be more pervasive. Fed Chairman Jerome Powell finally conceded that he’s going to refrain from using the word “transitory” in the future. Treasury Secretary Janet Yellen testified in front of Congress and said the same thing.
This is not the ’70s. But that doesn’t mean we should ignore the experience of the ’70s insofar as the types of lessons they teach us in diagnosing and responding to inflationary pressures.
This interview has been condensed and edited for length and clarity. An abbreviated version was published in our print issue.