It might be time to admit we just don’t know that much about inflation

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Why did economists fail to see inflation coming? Why did central banks stumble in the battle to control rising prices? It’s easy to blame the problem on politics, on complacency or on the specific issues around the pandemic, but what seems to fit the facts best is a simpler explanation.

There is just a lot we don’t understand about inflation.

Pointing this out is not intended as a swipe at central bankers or economists. They are smart people doing difficult work.

Rather, the issue here is that modern economies are infernally complicated. While economists can explain inflation in theory, there is huge practical uncertainty about how to predict inflation and, even more so, about how to control it.

One of the most frank admissions of these problems comes from Daniel Tarullo, a former governor of the U.S. Federal Reserve. In 2017, as Mr. Tarullo was stepping down after eight years as a senior policy maker at the world’s most powerful central bank, he wrote an essay called “Monetary policy without a working theory of inflation.”

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The title sums up what he discovered during his time at the Fed. Mr. Tarullo, a lawyer with expertise in financial regulation, was appointed to the Fed’s governing council as the financial crisis was unfolding. As he scrambled to educate himself about the background to key decisions outside his specialty, he found himself scratching his head over the explanations he was receiving.

The Fed’s policy making, he discovered, depended heavily on a handful of imposing-sounding concepts: potential gross domestic product, the neutral rate of interest and the natural level of unemployment, among others. The problem was that none of these things could be observed directly. They could only be roughly estimated based on less-than-perfect models of what experts thought was happening.

This did not strike Mr. Tarullo as a particularly reliable way to make decisions, especially since the interaction among parts of the economy was shifting over time in ways that were hard to assess. Take the Phillips curve, which was supposed to gauge a trade-off between higher unemployment and lower inflation. This relationship has diminished – maybe even vanished – over the past generation, yet the Phillips curve still seemed to play a role in the Fed’s thinking.

Mr. Tarullo emphasized that he wasn’t the only one aware of such pitfalls. Researchers and colleagues recognized the issues and were working to find better solutions. Still, his ultimate judgment after nearly a decade inside the Fed was damning. “We do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time policy-making,” he wrote.

Five years ago, when his paper was published, Mr. Tarullo’s complaint was a 10-minute sensation among people interested in monetary policy – which is to say, practically no one. But now, with inflation running at its highest level in decades in both Canada and the United States, his message resonates.

Consider the knotty question of what has driven inflation to its highest level in decades. The most popular explanation blames governments for doing too much to stimulate their economies during the pandemic with gobs of stimulus money and near-zero interest rates.

Another view argues that inflation is primarily a result of a sudden shift in buying patterns caused by locked-down consumers splurging on manufactured goods. This has overwhelmed supply chains and made them vulnerable to further disruptions caused by Russia’s invasion of Ukraine and China’s lockdown of key cities to control COVID-19 outbreaks.

Still other theories pin responsibility on greedy corporations, or short-sighted energy policies, or central bank policies designed to ease long-term interest rates.

Trying to sort through this muddle is difficult. A report this week from the Federal Reserve of San Francisco crunches numbers and concludes the biggest factor is supply issues, ranging from shipping delays to labour shortages. These seem to explain about half the jump in inflation over the past year. Demand factors – all that stimulus money – account for about a third. And unexplained stuff fills in the rest.

Other people place the emphasis differently. The Roosevelt Institute, a left-leaning U.S. think tank, argued in another report this week that supply and demand are both playing roles in boosting inflation. But the institute stressed that corporate profits are booming, and that unrestrained corporate power is an underappreciated factor in the current mess.

It’s not exactly news that economists disagree. But such debates matter because they carry over into discussions about how to deal with the problem.

If you think the big issue is too much money sloshing around the economy, you may conclude the only solution is to destroy demand by hiking interest rates to brutal levels. If you view the problem as more a supply challenge, you will be inclined to have a lighter touch on interest rates, put more emphasis on unclogging supply chains and be in favour of support for low-income workers. If you see corporate power as a contributing factor, you may lean toward higher taxes on windfall gains. And so on.

In an ideal world, we would possess a firm understanding of how much impact each of these policy options would have. But remember Mr. Tarullo’s essay. It seems policy makers may not have radically more insight into the situation than any of us.

Have some sympathy for the experts. But also be aware of the practical implications. At a time when inflation is surging and central bankers are taking flack from all sides, they are not likely to wait around for supply chains to unclog or to experiment with novel policy options. They will most probably rely on what has worked to control rising prices in the past: hiking interest rates until the economy squeals. It’s simple, it’s painful, but, hey, it works.

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