Spare the bear: the inflation debate that should be happening

Sep 14, 2022
  • BlackRock

By Jean Boivin and Alex Brazier | Remember Knut the polar bear? Shortly after his birth at Berlin Zoo in 2006, he was rejected by his mother. A zookeeper stepped in to raise him by bottle.i But some argued it would be better for the bear to be killed than raised by humans. “They should have the courage to let the bear die”, said the director of the Aachen Zoo. A media frenzy and widespread protests followed, ultimately saving Knut’s life.


To our mind, central bankers seem to have a bit of a “let the bear die” mentality right now (for bear, read the economy). Come with us on this one…! It seems they would rather just let the economy die to avoid any risk of inflation expectations de-anchoring (i.e. people believing that permanently higher inflation is a foregone conclusion from now on).


They may be right. But it’s not as simple as they make out. There is no perfect outcome, and a debate is needed about the relative merits of those available.


Let us explain further.

Ignoring the growth cost

If there were no trade-off between inflation and growth, central banking would be easy. Managing the trade-off between the two – and being forward-looking about it – used to be a core tenet of central bank policymaking. But that’s absent from the current debate, precisely when it’s needed more than ever.


Why more than ever? We’re in a new regime where that trade-off between growth and inflation is even sharper – largely due to production constraints in the economy, as we explained in a previous post. We don’t see those production constraints easing quickly. This puts central banks between a rock and a hard place. Yet, while they have started to acknowledge the sharper trade-off, they continue to focus solely on managing the inflation side of it. Federal Reserve Chair Powell emphasized that the “responsibility to deliver price stability is unconditional.”ii Isabel Schnabel, Executive Board member of the European Central Bank (ECB), said “regaining and preserving trust requires us to bring inflation back to target quickly.”iii


But they are mostly silent about the collateral damage. For hikes to reduce inflation, they need to hurt growth. There is no way around this. How much they will hurt needs to be part of the equation. We estimate it would require a deep recession in the U.S., with around as much as a 2% hit to growth in the U.S. and 3 million more unemployed, and an even deeper recession in Europe.


Implicitly, central banks seem to believe that pain is trumped by the risk of inflation expectations de-anchoring – and that justifies aggressive rate hikes to “kill the bear.” Indeed, it would be justified if inflation expectations were unanchored. And it’s true that no one really has a good handle on how inflation expectations work: they’re anchored until they’re not. But contrary to when Paul Volcker took office as Fed chair in 1979, they remain anchored now. Unlike Volcker, they still have a stock of credibility to draw on.

Swerving the debate

By focusing solely on the theoretical de-anchoring of inflation expectations and ignoring the very real growth costs, both the Fed and the ECB are swerving a crucial debate that needs to be had: where should policymakers land on the inflation/growth trade-off and what is the appropriate speed at which inflation should come back down to the 2% target?


They each swerve that debate in different ways. The ECB argues for “robust control” – avoiding inflation expectations de-anchoring at all costs, irrespective of how likely this outcome is. By that logic, you would stay in your house for fear of being hit by a car if you go out. The Fed argues it can bring inflation quickly back down to 2% without a recession. Wishful thinking, by our estimates. In the UK, this manifests itself with authorities working at cross purposes: the Bank of England sees a deep recession as necessary to bring inflation down, while the government is trying to spend its way out of it.

What’s the alternative path for growth?

Central banks could reduce the hit to growth by taking longer to bring inflation back to target. That would give the economy a chance to find a new equilibrium as production capacity slowly recovers (see the An alternative path for growth chart). The cost of that choice is inflation staying somewhat higher for longer (see the pink line in A slower fall in inflation to protect growth chart). But if inflation expectations remain anchored, that would overall be a better outcome for society.

An alternative path for growth
Illustrative GDP scenarios, 2017-2025

Rather than bringing inflation down quickly by crushing demand down to current production capacity, central banks could press down less hard on demand and live with higher inflation

A slower fall in inflation to protect growth
Illustrative inflation scenarios, 2021-2026

Inflation would come down more slowly in a scenario where central banks give the economy a chance to find a new equilibrium as production capacity slowly recovers.

Forward-looking estimates may not come to pass. Source: BlackRock Investment Institute, September 2022. Notes: The top chart shows a stylized path for demand in a hypothetical economy, measured by real GDP (in orange), and a projection of pre-Covid trend activity (in yellow). The purple line shows how much production capacity may have fallen since the pandemic. The dark red line a hypothetical projection of GDP consistent with bringing inflation down to 2% by the end of 2024, while the pink line shows an alternative path in which inflation remains above 2% over the same period. The inflation paths consistent with these hypothetical scenarios are shown in the bottom chart.

Time for a proper debate

It has long been recognized that policymaker incentives might not align with the best outcome for society. A prime example is the historical temptation to overstimulate the economy in the short term for political gains.iv We could be seeing the opposite now. From the personal perspective of central bankers, the worst possible outcome is to be the next Arthur Burns. He went down in history as the man who allowed U.S. inflation to reach nearly 15% and inflation expectations to surge. From that perspective, causing a recession is not as bad an outcome, particularly if there is a chance to blame it on something else or spin it as a “Volcker moment” – Volcker successfully got inflation back under control by ramping up interest rates to an eyewatering 22%. But it’s not necessarily the best outcome for society.


That’s why a serious forward-looking debate needs to be had about the trade-off in its entirety. Killing the economy now would be an unnecessary step if inflation expectations remain anchored. But it could also prove less costly than what would be needed if inflation expectations did de-anchor.


This is the most difficult economic environment to navigate in half a century – even more than the financial crisis. The idea it is as simple as asserting “we will do whatever it takes” to bring inflation back down quickly is mistaken. There is no desirable outcome at this stage – the question is which is the least bad.


Ultimately, Knut was saved by a public outcry. Now our economies face a similar fate as Knut, but there is no outcry. It’s time for a proper debate.