Inflation has been defeated virtually everywhere except at the ballot box. That’s one lesson of a year of hard-fought elections on both sides of the Atlantic. Here’s another: Our standard toolkit for responding to big swings in the prices that matter most to voters, and the economy, needs an overhaul.
In Europe and the US, inflation and the high cost of living have been top concerns for voters who’ve been eager to punish incumbents for letting them happen. No matter that the headline rate of inflation in most countries is now back to normal or that controlling prices is supposed to be the central banks’ job. For politicians at the sharp end of this discontent, it’s tempting to conclude that when it comes to monetary policy, elected governments need more of a say. Why not, if they’re going to be blamed when it goes wrong?
Argentine President Javier Milei famously promised on the campaign trail to “blow up” the central bank, though he hasn’t shown any sign of doing so since taking office. Former President Donald Trump, the Republican nominee for the White House, wants to “have at least a say” in where interest rates go and thinks he’d do a better job in steering them. Diluting the Federal Reserve’s independence would be counterproductive, sending a signal to investors that the central bank would be more political and potentially more relaxed about inflation. That would translate into an increased risk premium on US debt and probably higher—not lower—interest rates over time.
But Trump also told Bloomberg Businessweek this summer that he had a plan to lower costs, “because if you could lower costs, you could then lower interest rates.” Here he has a point. Governments can and should be doing more to tackle supply-side price shocks, because we’re going to see plenty more of them and the current approach is far from ideal.
With climate change, trade wars and geopolitical conflict all on the rise, the price shocks of the future are more likely to resemble the inflationary ups and downs of the past few years than the bouts of inflation in the 1980s and ’90s that were caused by excess demand. Relying solely on interest rates to tackle this kind of “shockflation” isn’t just politically corrosive, it’s costly. It means waiting until a shock in one market has pushed up prices across the economy. Worse, as a recent paper for the European Parliament pointed out, by keeping interest rates higher, it becomes even more expensive to make long-term investments—in combating climate change, for example—that would make future price shocks less likely.
While tightening monetary policy is never popular, when inflation is fed by excessive demand, those higher rates at least happen after a period of rising incomes. By contrast, a central bank that raises interest rates after a supply-side shock, such as Russia’s invasion of Ukraine, kicks people when they’re down. Mortgage payments rise just as energy and food bills are also going through the roof. No wonder central banks in 2021 and 2022 were slow to get started on that path. Supply shocks also mean monetary and fiscal policy are likely to be pulling in different directions. The central bank ends up squeezing household spending with higher rates just as governments are spending billions on programs to cushion the cost-of-living crisis.
If we’re lucky, the recent period—with a global pandemic and a European war—will turn out to have been exceptional. But energy and food are precisely the sectors that could be a problem in the context of both climate change and the global effort to transition away from carbon. A more geopolitically fragmented world is also likely to mean more frequent and unpredictable disruptions in supply chains. And recent history has taught us that central banks can’t afford to dismiss the resulting inflation as “transitory.”
The bottom line is that every government ought to be thinking about how to do better the next time. We don’t have a full toolkit yet, and the best mix of policies will vary by country. But here are three early rules of the road.
First, preventing shocks from spreading means more intervention than we were taught in neoliberal Economics 101. But don’t turn off price signals altogether. In response to the jump in European gas prices in 2022, the early instinct of many market-oriented politicians was to let prices find their level and then see how much help households needed. This ended up generalizing the problem: Energy accounted for more than half of the rise in euro zone inflation from the start of 2021 to mid-2022. Another snag was it let a bunch of unaffected producers earn windfall profits, amplifying the shock and making help for households yet more expensive.
Another approach, which France and some others ultimately followed, was to prevent energy companies from passing on the increase in wholesale gas prices to customers. This shielded households and limited the pass-through to overall inflation. But it did nothing to ease the energy shortage itself, since households had little incentive to cut consumption. Nor did it avoid windfall profits for energy producers, who were compensated for the difference between the market price and the household cap. (Some of those were later clawed back through windfall taxes.)
Germany may have found a better way with its “gas price brake” in late 2022. This involved the government setting a price cap on energy well below the market level on 80% of the average household’s gas consumption of the previous year. Consumption above 80% had to be paid at full market prices, providing an incentive to conserve. The takeaway: Faced with a major change in market conditions, limit the size of the shock but keep the signaling power of higher prices in place.
A second rule: Governments must expect companies to use price shocks as an excuse to raise margins, especially if a few dominate an industry. According to the European Commission, 55% of the rise in domestic prices in the euro zone in 2022 was due to firms raising their markups. In the US, higher corporate profits played a smaller role overall, but accounted for 9 percentage points of the roughly 14% increase in the domestic price level from mid-2020 to mid-2022, according to research by the University of Massachusetts.
Vice President Kamala Harris, the Democratic standard bearer, has vowed to ban “price gouging,” but the root problem is the increased market concentration that allows it. Reversing this would not only boost long-term growth and productivity, it should also make the next supply shock less expensive for voters.
The third rule: If you want to tackle high costs for consumers, avoid policies that make the problem worse. Bloomberg Economics estimates that Trump’s plan to impose 60% tariffs on China and 20% tariffs on the rest of the world would shrink the US economy by 0.9% and push up prices by 4.4% over three years, propelling the Fed’s target measure of inflation back up to 3.7% in 2025. If other markets react, the damage would be that much greater.
The former president has suggested the revenue could be used to ease the burden on households in other areas such as child care. It’s difficult to see how the government could raise trillions of dollars from tariffs while also boosting employment and revenue for import-competing businesses. But whatever happens, these higher tariffs aren’t going to lower costs.
Harris risks falling into a similar trap with her plan to reduce housing costs, which leads with a promise of $25,000 in down payment support for first-time homebuyers. On its own, by stimulating demand, this would add to the upward pressure on rent and housing costs that has accounted for a third of the rise in US inflation since 2020. The rest of her plan would spend $40 billion on direct incentives to increase homebuilding and new home supply. Wisely, her advisers have recently suggested the extra building would have to come before the extra help for buyers.
Faced with a sharp spike in inflation induced by Covid-19 and war, central banks responded too late, and then with second-best, reactive tools. Voters want someone to blame for their higher bills, and so do politicians. What policymakers should be looking for instead are smarter ways to tackle these shocks at source.
This column doesn’t necessarily reflect the opinion of Bloomberg LP and its owners.
