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Let Them Eat Cake: Inflation Beyond Monetary Policy


Devika Dutt (@devikadutt) is a Berggruen Fellow at the University of Southern California and has a PhD in Economics from the University of Massachusetts Amherst.

This post is part of a symposium on inflationRead the rest of the symposium here.


The response to the pandemic has witnessed several unprecedented economic and social policies: universal income support, lockdowns, remote work, the cancellation of sovereign and other kinds of debt, and the extension of childcare support, to name but a few. Even the most conservative institutions, central banks, appeared far more patient of inflation pressures than in the past, permitting their economies to run hot in support of spending and employment. It was not until nearly eighteen months after the beginning of the pandemic that some major central banks started to discuss reversing their nearly-decade-long policy of monetary expansion.

However, central banks in many developing countries did not have the luxury of such forbearance. Central banks in many large emerging market economies could not lower interest rates as far as they would have liked to mitigate the collapse of demand caused by the pandemic, and, given their inflation targeting mandates, had to start raising interest rates far sooner than their richer country counterparts, despite an at best a faltering recovery. The Banco Central do Brasil has raised its benchmark policy rate 7 times since January 2021 to 9.25 percent from 2 percent. The South African Reserve Bank raised its benchmark rate by 25 basis points in November 2021 despite “little demand pressure”. The Reserve Bank of India is expected to keep its benchmark rate steady despite seeing record high rates of unemployment in 45 years. Similarly, the Central Banks of Nigeria, Ghana, Kenya, Egypt, Zambia, Angola, and Mozambique are likely to hold their benchmark rates steady, while the Central Bank of Russia is expected to increase its benchmark rate by 100 basis points.

When All You Have Is a Hammer

In a way, the responses by central banks in developing countries is in line with the conventional policy wisdom: when inflation goes up, so should interest rates to cool the economy down. However, the pandemic and its recessionary effects are far from over, and fiscal support has been much smaller in developing countries than it has been in the rich industrialized world (9 percent of GDP in rich countries, 3.4 percent of GDP in emerging market and middle income economies, and 1.8 percent of GDP in low income developing economies). So where are these inflationary pressures coming from? Much of the inflationary pressure in the developing world is due to increases in the prices of food and energy. This is not surprising: it has long been known that much of the inflation in developing economies is structural—that is, it is due to structural weaknesses like supply bottlenecks, missing infrastructure, and underdeveloped markets. Crop failures, global commodity price cycles, and movements in exchange rates often create a rise in prices due to either a failure of supply or an increase in prices unrelated to demand conditions. Could the French Revolution have been delayed had a hypothetical Central Bank raised interest rates in 18th century France to lower the price of bread?

The idea that there are several different sources of inflation—some of which are unrelated to demand pressures—is being increasingly recognized in the recent discourse around monetary policy in the advanced industrialized nations. Especially in the United States, many have argued that inflation is driven primarily by shortages of some goods, such as semiconductors, due to the failure of certain supply chains, and made worse by deteriorating infrastructure, especially around the movement of goods. Even President Biden has argued that only more investment is going to ease inflationary pressures. More generally, inflation can be a result of too much demand relative to the total output of the economy, a result of sudden increases in the prices of key commodities, or a result of changes in the exchange rate—especially if an economy imports a large share of key commodities like food and energy. Given this variety, there should be as many different tools to respond to inflation as there are sources of inflation. Making credit more expensive for banks and the financial system at large is not going to resolve issues of supply chains or reverse crop failures or reduce the price of energy when it is largely imported. It is absurd, then, that the consensus remains that only one type of policy level should be used to bring inflation under control. More generally, the Tinbergen rule for economic policy says that policymakers should have as many tools as they have independent policy objectives. Otherwise, a policy lever used to achieve one goal might lead to movement away from another objective. Therefore, while raising interest rates and engaging in quantitative tightening would relieve demand pressures arising from the fiscal stimulus given to the economy during the COVID-19 pandemic, it would also make investments in infrastructure, ports, and supply chains more expensive.

In developing countries, especially, inflation is structural and is driven on many occasions by failure of the food supply chain. While economists are well-aware of this (consider, for example, recent studies on inflation in Ethiopia, in African countries more broadly, and in India), they do not seem to adequately value policies other than monetary policy for responding to inflation. The established wisdom is that central banks in developing countries should remain “independent”, target inflation, and respond to rises in core inflation (the price index that does not include the volatile prices of commodities like food and energy). However, increasingly, the consensus is shifting with economists arguing that since food represents a large part of consumption baskets, Central Banks should respond to headline inflation. This argument has been fortified by relatively longer periods of secular increases in the price of food than before, instead of just being transitory. Furthermore, even if central banks did respond to food price inflation with monetary tightening, it will only reduce “second-round” impacts of food price inflation by putting further pressure on household and firms already affected by higher food prices, and thus may not have a large impact on the underlying source of inflation.

In fact, if inflation is largely a result of an increase in food prices, and central bank policies will have little effect on those prices, enacting such policies can harm the credibility of an inflation targeting Central Bank. Furthermore, using the same demand management tool of monetary contraction to fight inflation caused by an increase in food prices can be counterproductive: food inflation is already putting pressure on the budgets of households and firms and a monetary tightening would only worsen it.

Expanding the Toolbox

Investment in structural change is what can ease these pressures. It is quite shocking, then, that massive public investments in agricultural infrastructure are not part of the inflation discourse. Building irrigation systems and warehouse infrastructure should be a part of the discourse to reduce structural inflation in the long term, as should investment in roads, freight rail lines, and a reliable and substantive cold chain, among other things. Typically, any public investment is evaluated in terms of very narrowly defined costs and benefits, primarily from the standpoint of public finances: is this public investment going to generate enough returns to the government so that is not a loss-making endeavor? Especially in light of the substantial fiscal constraints faced by governments in developing countries and the continued advice of international institutions around returning to fiscal austerity, it does not appear that there seems to be a substantial focus on reducing the long-term structural inflationary pressures. Trade agreements that make an economy more dependent on imported food or energy should also be evaluated from an inflation standpoint. National investments in sustainable energy that will reduce the price of energy in the long term and increase its stability should also be evaluated from an inflation standpoint. In the short-term, governments should be open to using strategic price controls and food subsidy programs. Central banks can also play a role in this regard by having targeted credit policies to encourage lending and investment in infrastructure that can alleviate inflationary pressures in the long-term. Regulation of financial markets and trading of food commodity futures and forward markets to prevent large swings in food prices should also be part of the inflation control toolbox.   

Even though Milton Friedman’s monetarist doctrine that inflation is everywhere and always a monetary phenomenon has been largely discredited, the dominant global policy approach to inflation still appears to be based on that notion. Responding to inflation has become the sole preserve of Central Banks through monetary policy. And according to this kind of thinking, there is nothing more a government can or should do than maintain a balanced budget and leave the Central Bank to do its job without interference. This is a short-sighted view and needs to be discarded. An inflation targeting monetary policy alone can neither manage inflation nor improve the credibility of Central Banks to do so.