The writer is a former central banker and a professor of finance at the University of Chicago’s Booth School of Business
As central bankers meet in Jackson Hole, they must wonder how far they have fallen in the public’s eyes. A short while ago, they were heroes, supporting feeble growth with unconventional monetary policies, promoting the hiring of minorities by allowing the labour market to run a little hot, and even trying to hold back climate change, all the while berating paralysed legislatures to do more. Now they stand accused of flubbing their most important task, keeping inflation low and stable. Politicians, sniffing blood and mistrustful of the power of unelected officials, want to re-examine central bank mandates.
Hindsight is, of course, 20/20. The pandemic was unprecedented, and its consequences for the globalised economy very hard to predict. The fiscal response, perhaps more generous because polarised legislatures could not agree on whom to exclude, was not easy to forecast. Few thought Vladimir Putin would go to war, and send energy and food prices skyrocketing.
Yet undoubtedly, central bankers were slow to react to growing signs of inflation. In part, they believed they were still in the post-2008 financial crisis regime, when every price spike, even of oil, barely affected the overall price level. In an attempt to boost excessively low inflation, the Fed even changed its framework during the pandemic, announcing it would be less reactive to anticipated inflation and would keep policies more accommodative for longer. This was the right framework for an era of structurally low demand and weak inflation, but exactly the wrong one to espouse just as inflation was about to take off and every price increase fuelled another. But who knew the times were a-changing?
Even with perfect foresight — and in reality they are no better informed than capable market players — central bankers may still have been behind the curve. This is understandable. A central bank cools inflation by slowing economic growth. No matter how independent it is, its policies have to be seen as reasonable, or else it loses its independence.
With governments having spent trillions to support their economies, employment just recovered from terrible lows and inflation barely noticeable for over a decade, only a foolhardy central banker would have raised rates to disrupt growth if the public did not yet see inflation as a danger. Put differently, pre-emptive rate rises that slowed growth would have lacked public legitimacy — especially if they were successful and inflation did not rise subsequently. Central banks needed the public to see higher inflation to be able to take strong measures against it.
So what happens now? The Fed’s determined policies are having some effect on economic activity. But it is a matter of guesswork how high policy rates will have to go, and how long they must stay high to cool the hot labour market. The task of the European Central Bank and Bank of England is harder because they will be tightening into recessions and energy prices account for more of the inflationary surge than in the US. They have to gauge how much tightening will contain inflationary expectations without exacerbating the supply constraint-induced downturn.
Central bankers know the battle against high inflation well and have the tools to combat it. They should be free to do their job. This is not a time for postmortems to assess central bank functioning. Spending to alleviate the pain of high inflation and slowing growth can help, but governments should direct this only towards the most needy so that it does not spur more inflation.
Of course, when central banks succeed in bringing inflation down, we will probably return to a low-growth world. It is hard to see what would offset the headwinds of ageing populations, a slowing China and a suspicious, militarising, deglobalising world. That low-inflation, low-growth world is one central bankers understand less well. The tools central bankers used after the financial crisis, such as quantitative easing, were not particularly effective in enhancing growth. Furthermore, aggressive central bank actions could precipitate more financial sector instability.
When all settles back down, what should central bank mandates look like? In matters such as combating climate change or promoting inclusive employment, the policies of central banks have only indirect impact. Truly, these are tasks for governments. Central banks should not use the excuse of government paralysis to step into the breach.
Clearly, they should re-emphasise their mandate to combat high inflation. What if inflation is too low? Perhaps like the virus, we should learn to live with it. Arguably, so long as low inflation does not collapse into a deflationary spiral, central banks should not fret excessively about it. Decades of low inflation in Japan have not exacerbated its problems, which are more directly attributable to population ageing and a shrinking labour force.
Central banks may also need a stronger mandate to maintain financial stability — for an extended period of low inflation fuels higher asset prices, and consequently leverage. Will these twin mandates condemn the world to low growth? No, but they will place the onus for fostering growth back on the private sector and governments, where they belong. More focused and less interventionist central banks would probably deliver better outcomes than the high-inflation, high-leverage, low-growth world we now find ourselves in.
Are we heading towards a global recession? Our economics editor Chris Giles and US economics editor Colby Smith discussed this and how different countries are likely to react in our latest IG Live. Watch it here.
Source: Economy - ft.com
