How to build back better

Why inflation could be a problem - and productivity the solution

15 April 2021 Stephen King, Senior Economic Adviser

    Huge economic rebounds as pandemic lockdowns end won’t alone solve the developed world’s underlying problems. In recent decades it has been characterised by weak growth, low wages, underwhelming productivity gains, inflationary undershoots, surging asset prices, rock-bottom interest rates, booming profits and rising income inequality.

    The persistent structural decline in the ‘natural’ rate of interest has been driven partly by ageing populations and by productivity. Indeed, these factors are linked: older people demand higher dividends, encouraging companies to distribute profits instead of investing in productivity gains.

    So low interest rates, rather than being a cause of faster future growth are a consequence of serious structural deficiencies. Central banks are merely accomplices in a world seemingly condemned to zero rates for years to come.

    Yet if policymakers cannot easily change demographic trends, they can influence productivity and government debt, both of which impact hugely on the natural rate of interest.

    However, raising government debt while ensuring a return to economic normality is difficult. Japan’s public borrowing has soared but the country suffers weak growth, deflation and minimal interest rates. Its old-age dependency ratio began rising rapidly in the 1990s, just as long-term growth stalled.

    Higher inflation should lead to higher nominal, if not higher real, interest rates, and that seems to be the aim of the new US ‘average inflation target’ policy. But if investors price in rate increases earlier than the central banks are indicating, causing asset values to fall, they could trigger an even bigger economic slowdown, thereby limiting the room for both inflation and interest rates to rise.

    Productivity – producing more from the same inputs – has made us richer than our forebears. Yet macroeconomic policies have focused in recent years on providing demand stimulus when the absence of growth stems much more from poor productivity gains.

    Little attention has been paid to the potentially retarding role of macroeconomic policy. Central banks have lowered policy rates in line with the declining natural rate, but lasting economic success will be signalled only when both rates can rise sustainably.

    The persistence of unconventional monetary policies, including asset purchases, has distorted property and share prices and investment decisions while supporting inefficient companies and squeezing out opportunities for more productive ventures, keeping the natural rate of interest at unprecedented low levels.

    So it is a trap. Policy rates cannot rise until there is clear evidence that the natural rate of interest has sustainably risen. But that cannot happen if central banks are unable or unwilling to end asset-purchase schemes on which governments increasingly rely for funding.

    We have become dependent on macroeconomic answers to what may increasingly be microeconomic problems and the answers may merely be making those problems worse.

    New post-pandemic policies may change the nature of our economic problems without providing lasting solutions. Swapping deflation for inflation might allow interest rates to rise without any lasting impact on either the natural rate or, indeed, productivity growth.

    Policymakers need to focus much more on solving the productivity puzzle, looking at education, how technology forces some workers into low-skill jobs, why some places are starved of investment, and which macroeconomic policies may be distorting the allocation of capital.

    First published 7 April 2021.

    Would you like to find out more? Click here to read the full report (you must be a subscriber to HSBC Global Research).

    Disclosure and disclaimer

    More, collapsed
    Anatomy of the UK consumer
    Our survey of 2,000 Britons shows how purchasing and attitudes are changing
    Join the conversation?

    Join our Linkedin group to get an unparalleled view of macro and microeconomic events and trends from a bank that is a leader in both developed and emerging markets.