Reserve Bank Governor Adrian Orr has come back from the annual Jackson Hole get-together of top central bankers with a view the world's productive capacity has been reduced by Covid, climate change and war in a way that central banks will have to respond to.
Less productive capacity means central banks will have to bear down on demand with higher interest rates to get inflation back down into their target bands, he says.
Orr was speaking in an interview for When The Facts Change, a weekly podcast I do via The Spinoff just after returning from the Jackson Hole symposium.
"That perspective of just how high inflation is globally is critical. The world is poorer. We've had true economic shocks, where the potential growth rates of countries are very inhibited by higher energy costs, a lack of labor resources, war, trade, all of these things," Orr said.
He noted the change in tone since last year's symposium, when Federal Reserve Chair Jerome Powell talked about inflation being transitory. This time Powell was much less relaxed about inflation.
"Without doubt, the tone changed considerably," Orr said.
"Jerome Powell set two records in his speech the other day, he came in under eight minutes for a monetary policy speech. So that must be amongst the world's shortest. And he took around 3% off global equity markets, so must be around one of the world's most expensive speeches. They say small things are generally more expensive, and he delivered," he said.
"He is reminding people that, first and foremost, their primary concern is maintaining low and stable inflation. And yes, people have underestimated the scale and persistence of the shocks that the globe is going through at the moment, mostly with regard to just once the economy shrinks, and its capacity to produce, once labor is scarce, capital is scarce, energy is more expensive, the inflationary pressures are much higher and more persistent."
Orr said the symposium was focused on how the supply potential of economies had changed.
"So now the US, the rest of Europe are saying, well, this really is a permanent dent in our capability to produce goods and services without generating inflation. And so they're having to tighten policy. They want to win the day on credibility. You cannot have maximum sustainable employment without low and stable inflation. So that's their primary goal," he said.
Central bankers were now having to educate markets that rate cuts may not happen for some time.
"There will be a prolonged period where economic demand has to be reduced to below the potential growth rate of the economy, to take the inflation pressures out," he said.
"Earth is now poorer. We've got a sudden realization around climate change, and so we're seeing for any one investment, the returns are different or less. We've got much higher input costs, energy, much higher consumption costs, food. Whilst employment levels have remained where they are, hours of work are declining so we've got less supply capacity. And war does nothing to long term growth potential for a country."
And obviously you're seeing geopolitical tensions, particularly in the Europe area, but everywhere. So these are areas where the world's capacity to produce has shrunk, in part temporarily, some of these things were resolved themselves supply chains, and in other parts, there is a fundamental change in investment needs for countries.
A lot of academic research released at the symposium was trying to understand "how much of this was going to set us on a lower permanent growth trajectory, versus a back to normal."
"But normal was always much lower than what was being priced in the markets," he said.
"The signals are that long run growth is going to be on a lower trajectory, then say in the beginning of this century. So the lower trajectory is in part around demographics, it's part around the shocks I've just talked about, the climate change shocks, part around the pandemic supply chains."
Changing trade and work patterns
Orr pointed to more permanent changes in global logistics systems and with more people working from home.
"You're seeing a change in your behaviour around regional trade now. Rather than 'just in time stocking, it's just in case stocking', you are seeing quite a lot of general change in economic behaviour that is not conducive to innovation or increasing higher growth. It's constraining it at the moment," he said.
However, productivity may have improved in some areas where working from home allowed more output from less hours worked.
"You can get a significant lift in productivity. People are far more focused. Less hours to achieve the same outcome. Less commuting, less fixed cost to doing business in a lot of ways. But it does challenge other means. Are we losing innovation by not being together and sharing ideas and chatting? Do we have disconnected labor forces. People who have never actually met their colleagues. That is now a real thing," he said.
"In the long run over the next five to 10 years, I would say productivity and per capita growth will be back to a steady state level of what we saw pre-Covid. But we have to remember that level was a low growth level. It was not a boom period. Throwing more resources at the same thing has been a means of growth for some large parts of the world. But that's not productivity enhancing, that's coming to an end."
No new China labour force to find
Orr said some of the 'easy' productive capacity gains of the past may have finished.
"The labour force of China has now been discovered, and it's now being embedded. So we were missing that big, free lunch we had for a while around just more and more people doing the same thing. Now we have to either do the same thing better or better things," he said.
Orr agreed that the Phillips Curve had appeared to have steepened again. The curve measures the trade-off between inflation and unemployment.
"These things are always non-linear. At some point, it bites. And that was the real revelation. That was what Jay Powell in his eight minutes was saying. 'We've hit that limit. There is not much more we can do other than tighten. Demand has to slow. It has to be below potential output. Full stop. And no ambiguity in that," he said.
"The perspective that I think people are missing is: we have had a wealth shock. We are poorer as citizens of planet Earth, because of this Covid, because of the climate change implications, because we keep going back to war. Monetary policy can smooth the pain through time, or shift it between sectors, but it can't avoid pain being met."
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