It’s probably not much fun being a central banker these days. They’re blamed for letting inflation get out of hand and then blamed for increasing interest rates in response. Their main job is maintaining price stability, something conspicuously absent over the past 12 months in Europe and the United States. Will the surge of inflation be brought to an early end or could it spiral further? The spotlight is on central banks; they will have to take control.
The tools the central banker has to slow inflation operate by increasing interest rates, thereby choking off spending plans in the economy and restoring balance between demand and supply. But there is a cost: a rate increase is usually followed by a period of increased unemployment before expectations of continuing inflation are banished, and actual inflation brought down. No wonder the bankers hesitate to act vigorously, for fear of being blamed for causing a recession, as happened in the early 1980s after Federal Reserve chair Paul Volcker raised interest to almost 20 per cent to vanquish the double-digit inflation triggered by the oil price shock of those years.
Furthermore, when an inflation spike has been caused by sudden and potentially transitory supply shortages, as have followed the pandemic and the Russian invasion of Ukraine, monetary policy textbooks caution against over-reaction.
It is more than 40 years since the main central banks last had to face this dilemma. Many thought that inflation had been squeezed out of their economies. For more than a decade after the great financial crisis broke out in 2008, it was falling prices that they were trying to avoid. When prices started to rise in 2021 the central banks expected or hoped that this would be a transitory affair consequent on the pandemic. But the persistence of inflation during 2022, and a gradual increase in forecasters’ expectations for next year and beyond, has shifted the balance towards timely decisive action to avoid inflationary expectations becoming more entrenched.
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Hence the new tone that was evident in the speeches at last week’s traditional late summer meeting of central bankers in the mountains of Wyoming. They do seem more determined to deal decisively with inflation despite the damaging side effects of doing so.
Not long ago, US Federal Reserve chair Jay Powell was expecting the US economy to continue to flourish while price stability was being restored. Now he speaks of the pain that the process will bring to households and businesses.
If having high fossil fuel prices accelerates innovation and behavioural changes leading to reduction in carbon emissions worldwide, that will be a good thing
For the ECB, which has so far been much slower than the Fed to raise interest rates, executive board member Isabel Schnabel argued for a path of determination, of robust control “even at the cost of higher unemployment”.
With language like this, some people might be tempted to ask: “Who do they think they are?” But the fact is that central banks have been granted independence from political interference precisely to enable them to deliver on the mandate of price stability and avoid a recurrence of the miserable stagflation of the 1970s. (In Ireland this independent mandate was approved in the 1992 Constitutional referendum by 69 per cent.)
No wonder, then, that central banks feel compelled to act decisively now, with the grumbling of some politicians (such as Liz Truss) getting louder. But let’s hope they don’t overdo the action.
There are lessons to be learned from the unforeseen emergence of high inflation. It is not all caused by the war in Ukraine. The pandemic has clearly been an important causal factor, not just because it blocked supply chains and removed workers from the labour force, but also because it triggered large spending by governments (especially in the US) to support the income of those affected by shutdowns. It might have been better if governments had chosen to finance this spending by a temporary tax surcharge: that would have soaked up some of the excess savings made by those who retained their jobs, and who now have the wherewithal to spend.
Are central banks to blame for having maintained a low interest rate regime for the past decade? Hardly, given how important it was to maintain aggregate demand and employment in those years. But the easy money conditions acted as kindling.
I doubt that central banks are out of the woods. Controlling inflation of the average price level does not mean restoring the old price relativities; in particular it does not imply bringing energy prices back in line with the rest. When average inflation is returned to 2 per cent annually, fuel prices are likely to still be relatively very high, thanks to geopolitical forces, and average real income will therefore still be lower.
If having high fossil fuel prices accelerates innovation and behavioural changes leading to reduction in carbon emissions worldwide, that will be a good thing. Meanwhile, though, governments will need to ensure that low income households and those depending on social welfare are cushioned from this shock; that cannot be accomplished by central banks, no matter how determined they are to get inflation under control.
Patrick Honohan was governor of the Central Bank of Ireland 2009-2015