Here’s some happy reading for the world’s central bankers this evening. It comes courtesy of the Bank for International Settlements’ general manager Agustín Carstens, who says the fixes they’ve relied upon for the past few decades belong in the trash: (emphasis ours here and elsewhere)
Central banks may also need to reassess how they respond to inflation resulting from supply side developments. These will typically spark relative price changes at first. The textbook prescription is to “look through” this type of inflation, because offsetting their impact on inflation would be costly. But that assumes inflation overshoots are temporary and not too large. Recent experience suggests it can be hard to make such clear-cut distinctions. What starts as temporary can become entrenched, as behaviour adapts if what starts that way goes far enough and lasts long enough. It’s hard to establish where that threshold lies, and we may find out only after it has been crossed.
Monetary policy frameworks have, in recent decades, been based on the idea that central banks can provide stable growth by controlling the level of aggregate demand in the economy. This is done by easing or tightening monetary policy. If the economy is overheating, and inflation is too high, rates can rise – hitting demand in the process. And vice versa if demand needs a little bit of a boost in order for the economy to reach its potential.
The framework implies that inflation is ultimately a demand-driven phenomenon. Any surge in prices resulting from supply shocks will be short-lived, as investment and government policy adjust to fill the gap.
That view has merit. It helps explain why the European Central Bank was wrong to respond to the rise in oil prices in 2011 by hiking rates only to be confronted with a sovereign debt crisis and recession a year down the line. But what happens when you have a situation like the present where supply bottlenecks linger and price pressures begin to broaden?
One consequence is that workers (in some parts of the world at least) begin to call for more money:
While we remain unconvinced that we’re about to see wages spiral out of control, it’s looking less likely that what we’re seeing happen to price growth is a blip.
So where do we go from here? Well, there are no easy answers. Combining rate rises with a cost of living crisis is hardly a recipe for societal bliss. In the longer term, however, persistently high inflation would be even worse. The BIS’s head somewhat glosses over the challenges this creates:
The good news is that central banks are awake to the risks. No one wants to repeat the 1970s. It seems clear that policy rates need to rise to levels that are more appropriate for the higher inflation environment. Most likely, this will require real interest rates to rise above neutral levels for a time in order to moderate demand.
Of course no-one wants a repeat of the stagflation for which that decade is renowned. Yet the idea that this generation of central bankers can draw on the Volcker playbook like it’s no biggie is barking.
Suppose what Carstens means by a “neutral” level is that real rates will rise to zero. Well right now that would mean the European Central Bank hiking its deposit rate, currently minus 0.5 per cent, by a whopping eight percentage points. The Federal Reserve would need to raise the federal funds rate by around 7.5 percentage points. At Threadneedle Street, the bank rate would have to shoot up by more than 5.5 percentage points.
Meanwhile, here’s what’s happened to debt levels over the past five years:
We said earlier this year that people seemed to be ignoring just how wildly out of sync real rates are with historical norms and warned that borrowing costs may have to rise by a far greater amount than realised. We’re not the head of the central bankers’ bank though, so it doesn’t really matter what we say. That Carstens now seems to be promoting the same view is altogether more concerning for anyone counting on relatively modest rate hikes.
It could be that debt burdens are so heavy that smaller moves will be good enough to choke off enough demand that prices begin to fall. Or we could get lucky and see inflation fall back towards the end of this year.
The BIS was one of the few to voice their concerns in the run-up to the great financial crisis. Central bankers largely ignored the warnings from Basel then. But if inflation persists, will they do so again? We’re not so sure.
Source: Economy - ft.com
