Martin Wolf and what to do about the commodity shock

Martin Wolf's column today reflects on the commodity shock on the basis of the data provided by the World Bank in the last Commodity Markets Outlook. As has been the prevailing consensus he suggests that this is an unprecedented shock, larger than the oil shocks of the 1970s, and any other commodity crises of the last 50 years.

In his words, based on the World Bank: "the initial impact of the closure of the strait was a global loss of 10.1mn barrels a day of oil in March. This was much larger than the impact of the Iranian revolution in 1979, the Arab oil embargo in 1973, Saddam Hussein’s invasion of Kuwait in 1990, or the Iran-Iraq war in the 1980s."

The current data on the price of oil has not yet confirmed these pessimistic predictions. The issue might be related to how much of a chockepoint the Strait of Hormuz really is, and how trade can adapt to it. Note that between 1967 and 1975 the Suez Canal was closed and forced oil shipments around the Cape of Good Hope. This caused a surge in transport costs, incentivized the development of massive supertankers, and forced a rerouting of trade, but it had limited initial impact on oil prices compared to the 1973 oil crisis.

It is obviously to soon to say, but so far the current oil shock has not lived to previous ones, when oil producing countries in OPEC had more power. Figure below shows the nominal and real price of Brent oil, which remain quite below the 1970s peaks.

Wolf is on the pessimistic side of things, and suggest, correctly on that, that costs will be unevenly distributed and that action to avoid worst problems is necessary.  He says: "this is a sizeable disruption, which is sure to hit many of the world’s poorest people and most vulnerable countries hard. The rise in oil and fertiliser prices guarantees that. This underlines the moral case for continuing to provide international assistance." That's all good, even if one is more cautious about possible outcomes.

But then he goes on to say that: "central banks are going to have a tricky time navigating the consequences. But they must not let inflationary expectations slip out of control." In other words, this is going to hurt the poor, and he thinks it will very much, since this is an unprecedented shock, but central banks should not care, and be concerned only with inflation expectations.

Before the Pandemic inflation there was some growing understanding, now less so, that inflationary expectations are not that relevant (on that see this). Jeremy Rudd wrote an article for ROKE suggesting that modern macroeconomics assigns too much importance to inflation expectations, with weak theoretical and empirical justification. Measures of inflation expectations (surveys, market-based) are noisy, inconsistent and weakly correlated with actual inflation outcomes. For him, this makes them unreliable as a key driver in models.

If inflation is caused by a hike in costs of production, there is very little that a hike in interest rate could do to control it, other than repress wage increases by slowing down the economy. Not that this should be a major concern in most advanced economies, at least.

My guess is that the impact will be smaller than expected, and that central banks will overreact. That might be the case of the Fed today, that should reduce rates, but probably won't because of inflationary expectations.

On the irrelevance of inflation expectations: the return of the working class

There are many myths about the Phillips Curve and the so-called Monetarist Counter-Revolution of the 1960s and 1970s. Forder's book is a good read on some of these issues. Jeremy Rudd's recent paper is also a must read, and has now been accepted for publication in the Review of Keynesian Economics (ROKE).

It debunks the myth about the importance of inflationary expectations for explaining the Great Inflation of the 1970s, and casts doubts about the Monetarist Counter Revolution, the Rational Expectations one, and that would include the more recent New Keynesian developments that include a lot from both. Rudd's paper suggests that there is a simpler explanation for the acceleration of inflation back then, and the Great Moderation since the 1990s. In his words:

"Another way of stating this point is that an important feature of inflation dynamics after the mid- 1990s appears to be the lack of a strong wage–price spiral (or of any significant year-to-year feedback between wage growth and inflation)... An observation about the actual nature of the 'wage bargaining process' is helpful at this point."

Old Keynesian stories about cost-push versus demand-pull inflation come back to mind. He suggests essentially that worker's wage bargaining power has been weakened, and that reflects in less impact of labor costs on actual inflation. Again, in his words:

"We can make a reasonable case that reactions of labor costs to actual inflation were an important feature of the inflation process in the 1970s. In particular, without this channel’s being present, it is nearly impossible to explain why movements in food prices left a durable imprint on core inflation—unlike energy, which can plausibly be viewed as a broader input to industry, changes in agricultural prices shouldn’t act like a cost shock to firms outside the food sector."

This suggests a preoccupation of the profession with more concrete, objective causes of inflation dynamics, and that bargaining power of the labor class matters. Martin Sandbu has suggested a few months ago in his Financial Times column that:

"To be precise, we may be witnessing the manifestation of two outmoded ideas: that the relative power of economic classes alters macroeconomic outcomes; and that macroeconomic policy tilts that relative power."

Sandbu also noted that in this recession it is Michal Kalecki, not Keynes, the old and forgotten master that we should bring back from the dead. While I do think that Kalecki should always be remembered and was and continues to be relevant, it is less clear that the wage bargaining position of the working class will recover anytime soon. Sure, if Dems manage to pass the more robust social spending bill, with the extra US$ 3.5 trillion, things would look a bite better. Hope springs eternal.