The central bank inflation-fighting paradox

  • Central banks continue to claim that current elevated inflation is transitory.
  • This is partly to reassure markets that monetary policy will not tighten (or not by much).
  • But higher inflation would only be transitory if central banks treated it as permanent.

Inflation remained above target in all major economies over the past month. True, US inflation eased by 0.1% in August compared with July, but this was hardly a major shift. Moreover, recent energy price developments imply that inflation will rise further in coming months, boosted by calendar effects (weak numbers a year ago). This is also true of smaller economies, e.g., Sweden, where underlying inflation (KPI-F) has been above the 2% target for three of the past five months.

As for producer prices, these are much higher, 8.3 in the US (year to August), 12.1% in the EA (July) and 11% in the UK (August). In Germany, the PPI reached a 37-year high of 12% in August. Nor is this likely to be the peak; both in the US and in the EA, consumers and businesses expect inflation to rise further.

In the face of higher inflation, central banks are generally sticking to the oft-reiterated view that current numbers are transitory – although in some cases, most recently the Fed, doubt is beginning to creep into their comments.

There are no doubt a number of reasons why central banks are holding on to the ‘inflation is transitory’ argument. One is presumably that they really do believe that inflation will ease over coming months. To believe otherwise would i.a. mean that they must re-examine the causes of inflation, perhaps even including abandoning decades of claiming that monetary developments do not matter, and that money is, on the whole, irrelevant. (Do central banks really think money is irrelevant? This is perhaps too harsh a comment. But they rarely refer to it, certainly downplaying its role in creating inflation. Why this is the case, in front of massive evidence highlighting the link between money and inflation, is more puzzling.)

Another reason is likely to be a desire to reassure markets. One of the consequences of the post-Great Recession era has been a shift in the balance of power between markets and central banks. Where markets were once central bank-dependent, central banks are now also to a large extent market-dependent. In other words, central banks are wary of doing anything that can cause markets to fall, let alone to panic. The best, but far from only example of this was the ‘taper tantrum’ in May and June 2013, and the Fed’s subsequent reaction to it. Hence, where central banks once gave the impression of being in control, they are now constrained by the likely market reaction to their action. With central bank action thus limited to those things that markets will accept, the question becomes who is really in control?

By sticking to the ‘transitory’ view, central banks are signalling to markets that there will be no severe tightening of monetary policy or massive withdrawal of liquidity. Yes, the Fed is tapering its purchases and both the Bank of England and the ECB will at some stage reach the end of theirs (and the ECB also talked guardedly about fewer purchases in the late summer). But this so far only involves a smaller inflow of liquidity, not an actual withdrawal.

Yet there is a paradox here. If central banks really wanted to ensure that current inflation would be transitory, the best policy would be to act as if it wasn’t. In other words, to take current developments more seriously and to be seen to be doing so. True, this might slow the post-pandemic recovery; but the world economy is currently growing very strongly. The OECD has just forecast 4.4% growth for 2022, following 5.8% in 2021. True, a slowdown – but also an upward revision from 4.2% for 2021 and 3.7% for 2022 in its December 2021 projection. 4½% global growth is very strong by historic standards. If policy cannot at least begin to be normalised now, when can it ever?

By contrast, if central banks persist in the view that transitory inflation means no need for countermeasures, they are in fact at the very least running the risk of entrenching not only inflation but also higher inflation expectations, both short-term and long-term. The shift from a world that expected inflation and got it (the world of, say, 1960-1990), to a world that, on the whole, didn’t expect it and didn’t get it (say 1990-2020) was both significant and hard-won. Admittedly, not all of this was thanks to central banks (global developments helped substantially), but they played an important role. Is it really worth throwing all this away for the sake of one or two percentage points (at most) of growth in 2022? (I am actually sceptical of the value of measuring inflation expectations, and there has just been a research paper published by the Federal Reserve which agrees with me; but central banks set great store by them, and so they are relevant.)

Si vis pacem, para bellum, says an old saying. If you want peace, prepare for war. It seems that this is just as valid for central banks: if you want low and stable inflation, make sure that you are prepared to fight for it.

Gabriel Stein

(With many thanks to John Nugée for insightful comments on the draft.)