Central Banks Didn't Tame Inflation for 30 Years — They Just Rode China's Coattails

Source: Patrick Boyle | Published: 2026-05-02T13:00:06Z

Pradhan and Goodhart argue that three decades of low inflation credited to central banks was really driven by China's cheap labor deflating goods prices — and that structural tailwind is now reversing as aging demographics, tariff walls, and fiscal deficits collide.

China Put the Phillips Curve in a Coma

The Phillips Curve is one of economics' oldest relationships: low unemployment pushes wages up, and prices follow. But over the past two decades, central banks slashed rates to rock bottom, unemployment hit historic lows, and inflation didn't budge. Economists declared the Phillips Curve dead. Central bankers took the credit.

Pradhan and Goodhart's core argument: the curve wasn't dead — China had put it in the ICU. Starting in the 1990s, baby boomers entered the workforce, female labor participation climbed, and China and Eastern Europe integrated into global trade. The world's effective labor supply nearly doubled. A labor supply shock of that magnitude is the most reliable way to suppress wages and prices. Central bankers looked at this structural gift and concluded it was their own financial genius.

Two Inflation Curves: One in China, One at Your Doorstep

Treating inflation as a single number misses the real story. Two inflation curves were running simultaneously.

The first is the domestic services curve — barbers, plumbers, lawyers, people who must physically be near you to do their job. Their prices are set by local labor markets, and this curve never broke down. The second is the goods curve, which for the past thirty years was essentially "Made in China." When you outsource most of your manufacturing to countries with cheaper labor, physical goods prices keep falling.

Goods deflation was so powerful it masked the fact that services inflation was functioning normally the entire time. Western central banks essentially outsourced their inflation targets to Chinese factories. Politicians enjoyed stable growth on cheap borrowing costs, service workers got steady raises, and nobody had to make hard decisions — because cheap TVs and clothing from China dragged the average down.

But that era is ending. China itself is aging faster than almost any major economy, and workers are shifting from export manufacturing to domestic services. Meanwhile, tariffs and trade barriers are preventing Chinese goods from reaching Western consumers at their old prices. The structural tailwind that made central banking look easy is being erased simultaneously by demographics, geopolitics, and deliberate policy choices.

The Fire Was Already Burning Before Anyone Poured Gasoline

Before the Strait of Hormuz closure, Peterson Institute president Adam Posen and Lazard CEO Peter Orszag warned back in January that U.S. inflation could hit 4% by year-end — double the Fed's target. Their argument had nothing to do with energy shocks.

Multiple forces are converging at once. The lagged pass-through from tariffs is still building — businesses have burned through pre-stocked inventory and are passing costs to consumers in small increments. The labor market is tighter than headline data suggests — several Fed banks estimate that the monthly job gains needed to keep unemployment stable have roughly halved since early 2024. Fiscal policy is extraordinarily loose, with the U.S. government projected to run a deficit exceeding 7% of GDP this year — a figure normally seen only during wars or severe recessions, not at full employment.

As Posen put it on the Odd Lots podcast: "The Fed did tighten, but the economy barely noticed."

Credit spreads are narrow, household wealth is at all-time highs, and private credit markets are providing nearly $2 trillion in alternative financing entirely outside the traditional banking system. The war simply poured gasoline on a fire that was already burning.

Baumol's String Quartet and the Government Budget Nightmare

In the 1960s, economist William Baumol asked a simple question: why does a string quartet performing Beethoven get paid more today than a century ago? The instruments haven't changed, the score hasn't changed, the headcount hasn't changed, and the musicians aren't any more productive. The answer: the rest of the economy got more productive — if you don't give musicians a raise, they'll put down their violins and work somewhere else.

The concept is called "Baumol's cost disease," and it doesn't just explain why concert tickets are expensive. It explains why government budgets worldwide face a structural nightmare. Healthcare and education are labor-intensive, in-person services where productivity gains are nearly impossible. A nurse, no matter how hard she works, can only care for one patient at a time. As populations age and neurodegenerative diseases and complex comorbidities surge, healthcare spending is locked on a trajectory that far outpaces GDP growth.

Japan has spent billions developing medical robots to engineer its way out of this problem, but only 2% of caregivers use them regularly. The elderly need human caregivers. And because those caregivers can choose to work in more productive sectors of the economy, you have to keep raising their pay just to maintain the same level of care. You're essentially paying more and more for a string quartet — except the quartet is your entire healthcare system, and the audience is getting older by the day.

Housing: The Biggest and Most Underestimated Piece of the Inflation Basket

Housing costs account for more than a third of the consumer price index — the single largest category. If you read the research predicting inflation will fall back, housing is almost entirely absent. That's a glaring omission.

As of March, U.S. housing costs were up 3% year-over-year, already above the Fed's 2% target. And the official CPI actually understates real-time pressure because it measures average rents across all existing leases, not what new tenants and buyers are actually paying. Tariffs have pushed up building material costs, a shrinking labor force has tightened the supply of construction workers, and mortgage rates above 6% have created a "lock-in effect" — existing homeowners refuse to sell because moving means giving up the low rate they locked in years ago. The result is a market with almost no supply, rising construction costs, and no relief mechanism in sight.

The deeper problem is generational gridlock: older homeowners vote in large numbers and have a direct financial interest in high home prices. Politicians who propose increasing supply are essentially asking their most reliable voters to accept a hit to their net worth — which is one reason this problem has persisted so long.

The Cycle of Selective Ignorance

A new NBER working paper reveals a disturbing pattern: "the cycle of selective ignorance." When inflation is low and stable, people simply don't pay attention to monetary policy — they don't know what the Fed is doing, don't know what the inflation target is. This is perfectly rational, the same way you don't read your homeowner's insurance policy until the ceiling starts leaking.

But when inflation spikes, people suddenly start paying close attention. The problem is that they're learning about monetary policy precisely when central banks appear to be failing, so the only lesson they absorb is a negative one. When people expect higher prices, they demand higher wages; businesses anticipate higher costs and raise prices preemptively; inflation becomes a self-reinforcing cycle — exactly what happened in the 1970s. The researchers note that the current trajectory of household inflation expectations tracks almost perfectly with the eve of the 1974 inflation surge.

The Cost of Redundancy: When Peaceful Oceans Are No Longer the Default

For thirty years, the world operated as one giant optimization machine — whatever was cheapest to make in Germany, China, or Taiwan got made there, then shipped across open, peaceful oceans. The system was supremely efficient and one of the most powerful deflationary forces of the modern era. But events at the Strait of Hormuz proved that open, peaceful oceans are no longer a given.

Adam Posen noted that Canada recently discovered it has virtually no internet infrastructure independent of the United States — all cables and satellites route through its southern neighbor. For decades this was perfectly fine, but when international relationships can shift overnight, that dependence becomes a vulnerability. Most countries have similar single points of failure; they just never thought to worry about them.

Now nations are being forced to build redundancy: duplicating supply chains, constructing backup energy infrastructure, reshoring manufacturing they were once happy to outsource. Poland and the Baltic states have sharply increased defense spending. Germany has launched new fiscal expansion to rebuild military capability. None of this adds to an economy's productive capacity, but all of it adds to deficits.

The Central Banker's Dilemma: When Political Pressure Becomes Irresistible

If the Fed wants to bring inflation down, it must maintain restrictive interest rates. But restrictive monetary policy makes government debt more expensive, slows the economy, and makes politicians uncomfortable — especially politicians running for reelection. Pradhan and Goodhart point out that in any prolonged conflict between a government and its central bank, the central bank always loses. This isn't a partisan observation; it has held true in every country, across every political spectrum, for as long as central banks have existed.

Turkey and Argentina show what happens when politicians seize full control of monetary policy: central bank governors are replaced frequently, the government forces the central bank to buy sovereign debt, and the currency's purchasing power collapses. Advanced economies are obviously in a different position — deeper capital markets, stronger institutions, and the enormous advantage of borrowing in their own currency. But the underlying mechanics of inflation don't change with the size of the economy. When governments run persistent deficits and refuse to cut spending or raise taxes, the pressure to monetize the debt — to quietly print the difference — is something no central bank can resist indefinitely. It is, in effect, a slow-motion tax on everyone holding that currency, and it doesn't require anyone's vote.

The Age of "Unanchoring"

Pradhan and Goodhart call this the era of "the unanchored central banker" — central banks can no longer single-mindedly pursue low, stable inflation. Not because the governors have become incompetent, but because the structural conditions that made them successful have been pulled away. Demographics have reversed, trade routes are contested, deficits are structural, and politicians are telling central banks what to do. The tailwind hasn't just died down — it's blowing straight into their faces.

As of now, the data suggests that the only group of people on Earth whose inflation expectations remain perfectly anchored at 2% are the members of the Federal Open Market Committee themselves.