He Foresaw Inflation. Here’s What He Expects Next. Feat. Lord Mervyn King

Episode Summary

Executive Summary: The episode revisits Mervyn King’s early inflation warning and debates why central banks missed it, how much of the 2021-22 surge came from money, fiscal transfers, supply bottlenecks, and expectations, and whether higher rates should now trigger recession. King argues easy money plus supply shocks made inflation inevitable and that central banks must accept a prolonged tightening cycle. Luigi Zingales pushes back, emphasizing fiscal stimulus, supply constraints, labor-supply shocks, and uncertainty about the 2% target.

Main Topics: Why inflation was missed in 2020-2021 (Priority: 5/5): King argues central banks were overly attached to models that treated inflation as driven mainly by expectations and ignored the simple monetary reality that too much money was chasing too few goods after the pandemic reduced supply. Central bank models vs. monetary reality (Priority: 5/5): A major critique is that inflation targets became circular theories, with the target itself treated as the anchor for expectations. King says models are useful for insights, not forecasts, and were misused as forecasting tools. Mervyn King’s policy outlook: higher rates, sticky core inflation, recession risk (Priority: 5/5): King believes headline inflation will fall as energy and food shocks unwind, but core/domestic inflation may stay sticky unless central banks keep tightening. He warns easing too soon could leave inflation stuck at 4-5% and require an even longer recession later. Luigi Zingales’s counterargument on causes of inflation (Priority: 5/5): Zingales argues the inflation surge was not just about expectations or broad money, but about fiscal transfers to households, supply bottlenecks, reduced labor supply, and later the war in Ukraine. He says 2021 and 2022 should be analyzed differently. Asset prices, interest rates, and the 'great repricing' (Priority: 4/5): King sees the era of ultra-low rates ending, implying broad asset repricing and weaker support for zombie firms. Zingales agrees higher rates can curb bubbles, but doubts they will solve productivity problems by themselves. Productivity, zombies, and structural adjustment (Priority: 4/5): King argues higher rates will force debt restructuring, remove zombie companies, and reallocate resources to more productive firms, potentially restoring long-run productivity growth. Debate over the 2% inflation target (Priority: 4/5): Zingales questions whether 2% is inherently special, while King says central banks must still defend it for credibility. Both agree that the target has become politically and intellectually difficult to sustain.

Key Arguments: Central banks relied too heavily on models where inflation was treated as an expectations-only phenomenon, which made them miss the obvious effect of money growth combined with reduced supply. The pandemic created a textbook inflation setup: supply contracted while central banks expanded demand through quantitative easing. Inflation targets became circular because the official target was treated as the anchor for expectations rather than something grounded in money and the real economy. The main short-term risk now is that headline inflation falls due to base effects, prompting central banks to stop tightening before core inflation is fully controlled. A recession is likely, and King sees some slowdown as necessary to bring inflation sustainably back to target. Higher interest rates will reduce asset prices because they raise the discount rate on future income streams, ending the long period of cheap credit. The end of ultra-low rates could help eliminate zombie firms and improve productivity by redirecting capital and labor to more efficient businesses. Zingales argues the 2021 inflation surge was driven heavily by fiscal stimulus, especially transfers to ordinary households, plus supply bottlenecks, not just monetary policy. Zingales contends the labor market shock came partly from reduced immigration, long COVID, fear of infection, and childcare/school disruptions, all of which lowered labor supply. Zingales questions whether forcing inflation from 4% to 2% is worth the recession it might require, and doubts the 2% figure has deep theoretical significance. The post-2008 period showed that asset-price inflation does not automatically translate into consumer inflation; where liquidity lands matters more than money growth alone.

Data Points: Inflation target: 2% - Repeated as the official target central banks are expected to defend, though Zingales questions its special status. Potential underlying inflation floor: 4% to 5% - King warns inflation could get stuck here if central banks ease off too soon. Broad money growth in the U.S.: 25% a year - King cites spring 2021 broad money growth as the fastest since the end of World War II. Headline inflation vs. core inflation in Europe: Headline inflation maybe twice as high as core inflation - King says headline inflation should fall as energy and food prices normalize, creating a risk of premature victory. Interest rates in the Volcker era: 20% - Used as the benchmark for Paul Volcker’s anti-inflation credibility. Productivity growth benchmark: 2% a year - King says this was roughly the historical average from 1900 to the financial crisis. Time horizon for inflation convergence: A couple of years / by this time next year - King says headline inflation may fall by next year, but core inflation could take years to return to target. Post-pandemic labor-force factors: Multiple - Zingales lists long COVID, fear of infection, reduced immigration, and school/childcare disruption as labor-supply shocks.

Pivotal Quotes: "inflation is driven entirely by expectations" — Mervyn King: King describes the central-bank framework he believes was mistaken. "too much money chasing too few goods" — Mervyn King: He summarizes the traditional monetary explanation for the pandemic-era inflation surge. "Why 2 and not 1 or 3?" — Luigi Zingales: He challenges the arbitrariness and policy significance of the 2% inflation target.

Implications: Central banks may need to keep rates restrictive longer than markets expect, risking recession but reducing the chance of entrenched inflation. The debate also suggests a broader rethink of models, fiscal-monetary interactions, and the true meaning of inflation targets.