Financial and Monetary Systems

How a muddled inflation debate imperils green investment

US dollars.

Image: Freepik.

Bill Morneau
Former Finance Minister, Canadian Government
Philipp Carlsson-Szlezak
Global Chief Economist, Boston Consulting Group
Paul Swartz
Executive Director, Senior Economist, Boston Consulting Group
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Financial and Monetary Systems

  • A common narrative is that the era of well-behaved inflation is behind us and that fiscal policy is to blame.
  • This has already undermined green investment plans on the premise that fiscal policy must be curtailed.
  • Yet, abandoning fiscal investment in the name of inflation risk is misguided – the defense of the inflation regime falls to monetary policy while fiscal investment must tackle strategic challenges.

The thrust of the public debate on inflation is that price growth is here to stay, that policymakers are “behind the curve”, and that the well-anchored inflation regime is crumbling. And, because of this, fiscal policy must step back from making bold new investments. The recent shelving of more than half a trillion US dollars of green investments in the US, because of inflation concerns, could augur a broader headwind.

While inflation risks are real and cannot be dismissed, shunning all fiscal policy is misguided. Fiscal investment is about building capacity over the long run, which can be deflationary, and should be decoupled from monetary policy that has a cyclical mandate. Moreover, the popular narrative of a breaking inflation regime should be challenged. The cost of rushing to conclusions, including nixing or delaying strategically urgent investments, can be high.

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To avoid hasty conclusions in a muddled debate, we should consider clear criteria to assess the impact of fiscal policies; critically question how the public debate frames inflation risks; and remind ourselves of inflation’s structural drivers and risks.

Sacrificing fiscal policy

There is no doubt that fiscal policy has contributed materially to current inflation pressures, as the US economy digests a demand overshoot and supply bottlenecks. Yet, while it is true that policymakers placed a risky bet when enacting extraordinarily large stimulus that should not preclude fiscal investments.

Stimulus checks are a fresh memory, but fiscal policy captures a wide range of efforts that deserve differentiation along a number of dimensions including:

  • Policy type. Cash transfers to households are digested like carbohydrates fueling demand without building capacity, whereas investments that induce capacity have the potential to be deflationary. Roads, bridges, and ports are the textbook examples but green investments can broaden energy supply and targeted child benefits can help pull in labor supply. Additionally, public investment in early-stage technologies that drive scale up and costs down can crowd in private investment as they become competitive.
  • Funding. If new policies are paid for with debt the demand shock is much greater than if financed with taxes that may result in reallocation of demand rather than its growth.
  • Timing. One-off checks can deliver astonishing amounts of money in weeks – the macroeconomic carbohydrates already mentioned. But large amounts of infrastructure spending would be digested over years while building the economic muscle that the protein of investment provides.

At the start of the pandemic, fiscal policy focused on short-term economic stabilization and, therefore, was aligned with monetary policy. Yet, as we look past the crisis, we need to return to letting fiscal and monetary policy play their differentiated roles. Fiscal policy is about long-run structural investments – contorting itself to accommodate monetary policy objectives, which are cyclical, does not sound right to us.

What drives the reluctance to allow for divergent objectives and horizons of fiscal and monetary policy? It surely has to do with high inflation, currently at levels not seen since the early 1980s, the tail end of the “bad macro” era when inflation was high, growth was poor, and painful recessions were necessary to bring things under control. Indeed, the 1970s have become a “mental model” for the public debate, with direct extrapolation of risks and a constant drumbeat of doomsaying.

Why the 1970s are a treacherous mental model

A better historical analogy may be the 1940s when consumer demand skyrocketed after the war while the supply side struggled to be repurposed from its war footing.

In Figure 1 below we juxtapose the squeeze of the 1940s with the break that began in the late 1960s. In the later episode, inflation never reset to low levels but posted ever higher lows as the inflation regime cracked, then crumbled, then collapsed – itself a multi-year process. The distinction is seen clearly through bond yields barely budging in the 1940s but moving sharply higher as investors demanded compensation for inflation they understood to be persistent in the 1960s and beyond.

Image: BCG.

Today, dynamics from both eras add to a backdrop of elevated risk. However, the rapid economic re-opening, led by surging consumer demand and a supply side struggling to adjust, along with bond yields so far looking past high inflation, leads us to believe that today is more like the 1940s squeeze than the 1960s break – and that inflation will moderate in the course of 2022.

Risks abound, with or without fiscal investments

That does not mean there are no risks – inflation risks are the highest in a generation – and despite expected moderation we are not returning to the pre-pandemic dynamics where the US Federal Reserve was fighting too low inflation.

In the quarters ahead, central bankers have the unenviable task to formulate monetary policy, treating all economic factors, including fiscal policy, as exogenous conditions.

Many critics have accused the Fed of being “behind the curve”, now desperately catching up with a runaway inflation problem by hiking four or five times in 2022. Yet, we disagree that the Fed is currently on a panicky path. A central bank that has lost the inflation battle would need to deliver a disorderly tightening of policy, surprising market expectations, and thereby deliver a recession to rein in runaway prices. It is too early to make the case this is needed.

That said, if inflation begins to entrench rather than moderate in 2022 it would be incumbent on the Fed to choose the painful, but ultimately less painful path, of delivering a recession to protect the inflation regime. The two most plausible risks that would entrench inflation are unhinging expectations and signs of a wage-price spiral. Today we are in the comforting situation where neither households nor markets show signs of cracking expectations, while wage growth, though high, runs below inflation, not above.

Amid all the risks, the Fed still stands a strong chance of bringing inflation under control. Indeed, as the economy continues to decelerate in 2022 and inflation moderates, the Fed’s rate path could face the opposite risk of too much tightening that triggers an unnecessary recession and painful unemployment. All this amounts to unusually treacherous territory – with or without additional fiscal investment.

COVID-19 has ended neither structural forces nor challenges

Like everyone else, we like to follow every wrinkle in the dataflow. But to avoid getting lost in the noise we strive to do so anchored by structural narrative.

Figure 2 below highlights that only durable goods prices are extraordinarily high. The other two components of inflation, non-durables and services, are elevated but not extraordinarily so.

Image: BCG.

Yet, if durables inflation is to stay so high we must be willing to argue that COVID-19 has ended the structural forces that have delivered durable goods deflation for decades, owing to the twin structural forces of global value chains and automation. COVID-19 has ended neither structural force – trade continues to grow, and we can think of nothing that would stop automation.

Just as we should remember that deflationary forces are likely to remain, we should not forget that structural challenges remain too. Some, such as green investment, are strategically urgent and will require continued and large investment.

Looking ahead, we should let fiscal be fiscal, and monetary be monetary. That means taking long-run structural investment decisions today and letting monetary policy, the true guardian of the inflation regime, take that into account. Today there remains a good chance of a soft landing with inflation under control. But if the inflation regime does turn out to be at risk, it falls to monetary policy to defend it – undercutting investments for the future will not win that battle and would lose another.

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