As ye sow, so shall ye reap

  • Survey data show surging inflation expectations
  • Central banks’ monetary ignorance meant they failed to manage inflation both below and above target
  • This double failure adds to the threats to central bank independence

Central banks spent much of 2020 believing that there would be no increase in inflation in spite of massive monetary stimuli; and much of 2021 claiming that the inflation that did (of course!) appear, would be ‘transient’. It is not quite clear exactly what ‘transient’ means in terms of time, but, presumably at least, it was intended to mean that inflation would subside rapidly enough to obviate the need for any central bank action. The Federal Reserve and (to a lesser extent) the Bank of England have now abandoned this stance. However, the ECB seems determined to cling to it, in spite of euro area headline inflation of 7.5% in the year to March and core inflation at 3%.

As it happens and as pointed out in my Comment last month, broad money growth has slowed sharply in the major economies. That argues that inflation will eventually subside, something that should be good news for central banks. However, that will take time. In addition, the burst to energy and other commodity prices – including food! – brought on by the Russian war of aggression against Ukraine, mean that inflation is now unlikely to peak until in the second half of 2022. Moreover, inflation is likely to remain uncomfortably high well into 2023. This argues that central banks still need to raise interest rates.

In addition, there is another factor. That is inflation expectations. As readers are aware, I am fairly sceptical of the value of inflation expectations when derived from bond market developments. However, I do set great store by business survey data on inflation. That is because these either (like the American ISM survey) measure what businesses have just paid relative to a previous period; or (like the European Commission surveys) what they expect their own sales prices to be in the near future. These are figures that any business executive will keep a very close eye on. They are as near to hard data as a survey can get. 

The US ISM manufacturing sector prices question reached 87.1 in March. This is slightly below the numbers reached in April, May and June last year – but those were the highest since 2008; and since reaching 92.1 in May 2021, the reading had dropped to 68.2 in December, before turning up again.

Meanwhile, in the EU business survey, near-term selling-price expectations in manufacturing reached an all-time (i.e., since 1985) high of 58 in March for the euro area. This compares with an all-time average reading of 7; and as recently as March last year, of 18. Historically, a reading of 10 is in the medium term consistent with inflation of 2%. The German reading was at 68, also an all-time high, as were the French, Italian and Spanish numbers. Consumer inflation expectations are also surging, with the latest EA reading at 60, up from 38 a month earlier and 19 a year earlier. Again, similar developments in the largest member states.

The data is important because these are the numbers that will affect behaviour in the economy. In other words, if households and companies see inflation remain unacceptably high and rising, and central bank action seems to be ineffectual, they will act on their own to protect themselves – by higher pay demands and by higher sales prices (PPI inflation is considerably higher than CPI). That is of course the way to a wage-price spiral that will make inflation feed on itself and ultimately necessitate much higher interest rates to halt it.

As concerns about the “cost of living crisis” spreads, central banks face two problems. The first was spelled out in last month’s Comment, namely the need to tighten monetary policy without over-reacting. This will be a complicated balancing act, since policy interest rates at the very least will have to become positive in real terms before having any significant impact on inflation.

The second problem is more long-term. It is that central banks, having so obviously gotten inflation wrong, risk seeing further demands for their independence to be curtailed. The current central bank paradigm rests very much on the notion that independent inflation-targeting central banks, with appointed technocratic boards, are able to take a much longer-term perspective than elected politicians and are therefore better placed to deal with inflation. But for years, inflation has undershot targets in the largest global economies and nothing central banks did seemed able to correct that. Nor did central banks seem able to explain why this happened. Now, inflation is substantially overshooting targets because central banks are once again failing to understand what is going on. This is at a time when their mandates are already being eroded by other tasks – for which they are eminently unsuited, such as climate change – are being added to the workload. The danger is that central banks’ double failure (undershooting and overshooting) will add to the calls to make them “democratically accountable”.

That would be regrettable, since independent (and, yes, inflation-targeting) central banks are actually a Good Thing (to quote 1066 and All That). Unfortunately, in this case, central banks very much have themselves to blame. Had they paid more attention to money, they would have had a much better understanding of what was going on, and might have made a better job of managing inflation – both on the downside and on the upside. Will this ‘money blindness’ now change? It doesn’t look like it.