Were central bankers lucky or smart in reducing inflation?
The Bank for International Settlements provided its usual challenge to central bankers last weekend, telling them they should think carefully and set a high bar before cutting interest rates.
For me, the more interesting section of the annual report from the central bankers’ bank was its assessment of the lessons learnt this century about controlling inflation, both when it is too high and too low.
There were five lessons highlighted by its leaders Agustín Carstens, Claudio Borio, Andréa Maechler and Hyun Song Shin.
Forceful monetary tightening can prevent inflation from transitioning from something no one needs to worry about to a high-inflation regime that annoys everyone
The deployment of the central bank balance sheet can stabilise the financial system at times of stress and prevent the economy from falling into a tailspin
But there are limits to prolonged monetary easing with diminishing returns and unwelcome side-effects
Monetary policy communication is tough, especially when central banks have lots of tools, their forecasts have failed and people expect officials to do better
Emerging economies have shown the benefits of foreign exchange intervention to ease trade-offs between price and financial stability
Many people will be able to sign up to all of those five lessons, although team transitory still have a problem with the first one. More controversial are the four thoughts about the future the BIS offered. It said:
Monetary frameworks should be robust to all sorts of economic conditions and stop relying on very difficult to measure concepts such as R-star
They should also be realistic in their ambition, with a greater tolerance for deviations in inflation below targets and more forceful action if inflation appears to take off
There should be bigger safety margins with tighter fiscal policy and efforts to limit excessive balance sheets that generate potential losses, with economic and political consequences. Central banks should also avoid zero interest rates outside crises
Central banks should be nimble and more careful with forward guidance that implies a commitment
This is a bit one-sided to me. Be quick to tighten, welcome tighter fiscal policy, don’t loosen when inflation is low and shrink balance sheets is a recipe for prudence, for sure, but also one for ensuring subpar economic performance. That comes with its own dangers.
Overall, however, this is the sort of report you would expect from the BIS. It will burnish its reputation as the body that sounds warnings about too loose policy when everyone else (including central banks) are partying.
Taking a victory lap
Another part of the annual report was as close as I have seen to central bankers whipping the punch bowl away from others and drinking all the booze themselves.
The BIS took quite the victory lap in chapter 2. It credited central bankers with a hugely successful response to the pandemic and its aftermath.
Central banks have risen to the challenge. Their forceful and repeated responses to financial stress stabilised the system and limited the damage to the economy. The shortfall of inflation from targets always remained contained. And following vigorous global tightening of the policy stance, inflation is now again returning to the price stability region while economic activity and labour markets have proved resilient
And later in the same chapter attributed the decline in inflation to powerful monetary policy.
The post-pandemic experience with inflation has shown once again one of the major strengths of monetary policy. In particular, it has highlighted how forceful monetary tightening can prevent high inflation from becoming entrenched. It has also confirmed central banks’ determination to avoid a repeat of the experience of the Great Inflation of the 1970s.
Specifically, the BIS said that higher interest rates curbed aggregate demand and this firm action was enhanced by the commitment to defeat inflation, which sent “a strong signal to markets, firms and workers that the central bank would do what it took to restore price stability”. All this prevented a 1970s-style inflationary psychology, the BIS said, alongside an easing in supply difficulties.
Weaker versions of these claims are reasonable. Demand does seem to be affected by higher interest rates, supply chains and labour force participation have improved (except for the UK) and messaging must be important to a degree. That said, the evidence presented by the BIS to support its claims is far from watertight.
Its first exhibit is a model simulation that shows higher inflation outcomes if people form inflation expectations based on inflation outcomes rather than a 2 per cent target. This analysis, however, assumes the answer that central banks would like to see in its construction.
A second exhibit, reproduced below, shows that inflation expectations at first contributed to the rise in inflation, and then to its fall after interest rates were raised sharply in 2022.
The problem with this sort of regression model, however, is that there is now a minor economics industry in producing “explanations” of the level or movement in the recent inflation episode. I have reported on the results from Ben Bernanke and Olivier Blanchard and, to put it bluntly, the results above do not match.
Or you can pick similar results from the IMF, reproduced below, which specifically show a very minor role for inflation expectations. Yes, the chart below is monthly and expressed in deviations of inflation from the 2019 level, not changes in it, but there is very little similarity.
The BIS might be right and its model results better than others, and expectations were important in determining inflation trends, but we all have to recognise that others disagree. A huge pinch of salt is needed when looking at “what caused the great inflation” analysis. The results are extremely sensitive to the precise assumptions and specification of the models.
The third piece of evidence employed by the BIS is to say that cyclically sensitive sectors saw more demand destruction than others in the recent disinflation. It produced the chart below as evidence.
Cross sectional scatter plots are troublesome at the best of times, but this one, where transportation and food are deemed the cyclical sectors, stretches credulity. We know that food and oil prices fell in this disinflation and normally we exclude these because they are distorted by global factors such as oil prices. Here, the analysis puts them centre stage and suggests that energy and food prices fell due to monetary policy. Let me gently say that the causality is not proven.
The BIS also highlights the limited movements in inflation expectations. This stability was clearly a success in this inflation episode, but the BIS goes too far when it attributes it solely to “forceful policy tightening”.
As my colleague Martin Sandbu has observed, stable inflation expectations could be caused by smart monetary policy or by everyone subconsciously realising that the inflation was caused by transitory supply shocks. He is correct that you would see the same trends in expectations under both explanations. I tend to accept the argument presented by the BIS, but not the evidence as proof.
My conclusion is that the hard evidence underpinning the BIS’s victory lap is a little thin.
With the same data, an alternative view is just as easy to produce. Last week Dario Perkins, managing director of global macro at TS Lombard, said in a research note that in his view central banks “got lucky and are now taking the credit for developments that were either beyond their control or would have happened anyway”.
“Let’s hope the authorities understand this because there is no guarantee their luck will hold,” he added.
In Perkins’ more cynical view, central bank figureheads Jay Powell, Christine Lagarde and Andrew Bailey raised interest rates forcefully because it would have been totally unforgivable to preside over prolonged inflation and they needed to cover their backs.
He thinks they have therefore tightened policy too much and things will not end happily.
Essentially, Perkins thinks that sharp rises in interest rates were unnecessary for a number of reasons. First, workers did not have the bargaining power of their counterparts in the 1970s. Second, fiscal loosening prompted the rise in inflation, but it was a one-off, so did not have lasting impact. Third, the monetary mistake was mitigated by improving supply chains, labour participation and the high degree of fixed-rate borrowing.
His evidence was similar to that of the BIS — circumstantial and not wholly convincing.
This is clearly a topic where a range of stories can be told that are not contradicted by the evidence, nor proved by it. I am not going to side one way or the other here, but I really want to know your opinion.
To what extent was the decline of inflation the result of monetary policy or luck? This is not a binary question, so weigh your answers carefully. Click here to vote. Your views are anonymous.
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