Central banks, cheap talk and costly signals

Central bankers talk about inflation more than a teenage boy thinks about sex. Perhaps they talk about it too much. In contrast to teenage boys, for whom less action would probably be a good thing, central banks would be well advised to talk less and act more. In the US, the Euro Area and the UK, the track record of inflation during the past few years has deteriorated to the point that a material loss of credibility may well be imminent for all three central banks involved – the Fed, the ECB and the Bank of England.

The chart below shows this track record. Note that the Euro Area was only created in 1999, so the pre-1999 data are for a synthetic Euro Area. The Bank of England did not achieve operational independence for monetary policy until June 1997. The Bank of England targets CPI inflation of 2 percent (until December 2003, it targeted a 2.5 percent inflation rate for the RPIX). The ECB targets CPI inflation below but close to 2 percent. No one knows what the Fed means by price stability. It may have ‘comfort zones’ for the inflation rate of the PCE deflator (core or headline) or of the CPI (core or headline), but the exact location of these comfort zones is even harder to determine than the location of comfort stations in an American city.


Monetary policy works mainly through expectations of future actions by the monetary authorities. To a lesser extent it works through the history of past actions. It works almost not at all through the current policy action, that is, through this month’s choice of the official policy rate. Expectations of future policy actions drive current asset prices (such as stock prices, bond prices, house prices, the exchange rate etc.) and rates of return, through intertemporal speculation and arbitrage. Expectations of future policy decisions also influence expectations of price and wage setters and of households and firms engaged in consumption and capital formation decisions.

If the current policy rate, unaugmented by the leverage of current actions, policy announcements and the private sector’s understanding of the policy rule, had to do all the work of controlling inflation and moving the output gap around, either monetary policy would not work at all or we would see humongous changes in the policy rate. This leverage depends on credibility – on the belief of market participants that the authorities will do what it takes, now and in the future, to meet their mandate – a price stability mandate in the Euro Area and in the UK, and a dual mandate (price stability and real economic activity) in the US.

Since the beginning of the decade, the Fed has been so unsuccessful in the pursuit of its price stability mandate, that its price stability credibility, if not shot, must be badly frayed at the edges. The variability of inflation has been signficantly higher in the US than in the Euro Area and in the UK, and the average rate of inflation in the US has also been higher.

Not surprisingly, mean inflation expectation one year ahead (according to the University of Michigan survey) now stand at 5.7 percent. Mean inflation expectations 5 to 10 years ahead are 3.5 percent. Loss of credibility in the Fed’s willingness and/or ability to maintain price stability is a fact – not surprising, given the institution’s willingness to cut rates massively and swiftly when the real economy turned down, despite continuing high inflation. The only question is how to regain credibility. Only actions, that is, rate increases, can do that now.
In the UK too, the anti-inflationary credibility of the Bank of England is slipping. In the Bank’s own survey, asked to give the current rate of inflation, respondents gave a median answer of 3.9%, a series high, compared with 3.2% in the November 2007 survey, the previous series high. Median expectations of the rate of inflation over the coming year were 3.3%, a series high, compared with 3.0% in November, the previous series high.

The ECB has been talking more toughly about the overriding importance of price stability than even the Bank of England. Yet the Euro Area inflation rate is and has been for quite a while, higher than the UK inflation rate, despite the ECB’s inflation-target-that-dare-not-speak-its-name being slightly south of the UK’s. Not raising rates when inflation is so clearly above target, and is expected to remain above target over horizons at which the ECB can influence it, is to undermine the ECB’s antiinflationary credibility. Unfortunately, good Euro-Area-wide survey-based inflation expectations data are hard to find. Asset market-based inflation expectations in the Euro Area as in the US and the UK (based on nominal and index-linked sovereign debt instruments or derived from inflation swaps) are flawed for a number of reasons, of which the existence of a (positive or negative) inflation risk premium may not be as important as a number of technical market distortions.

When the markets and wage and price setters in the wider economy are not sure about the objectives, independence, courage or judgement of the monetary policy makers, they want a signal from the central bank to convice them that the central bank means business. This signal must be expensive, otherwise it is cheap talk. The economic conjuncture today permits a costly signal that will separate the wheat from the chaff. Raising rates now will undoubtedly deepen the economic slowdown and may turn it into a recession. Inflation wimps will therefore not do so. Hairy-chested inflation foes will.

Financial stability concerns, which remain serious, should not stand in the way of policy rate increases. The risk-free short nominal interest rate has little if anything to do with the kind of liquidity crunch that has plagued the markets since August 9, 2007. Should the liquidity squeeze take a turn for the worse, then central banks can increase their activity as lenders of last resort and market makers of last resort; they can expand liquidity at whatever the level of the policy rate happens to be.

Possible liquidity-enhancing measures include the following: a wider range of eligible collateral at the discount window, in repos and at the range of special funds, schemes and facilities that have been created (punitively priced of course, to minimize moral hazard); a wider range of eligible counterparties (subject to proper regulatory requirements of course) at the discount window and in repos; longer maturities for collateralised loans; and if necessary the outright purchase of illiquid assets (at properly punitive prices).

Escapists, when they cannot meet a target have an easy solution: change the target. It is key to resist the siren songs calling for a change (read: increase) in the numerical value of the inflation target or a modification of the inflation index to core inflation or some other price index that happens to have produced lower inflation numbers in the recent past.

Changing the objective of the central bank in the UK or the Eurozone from being lexicographic or hierarchical – with price stability coming first and real economic activity only subject to or without prejudice to the price stability target being met – to involving a trade-off between deviations of inflation from its target and the output gap would be the ultimate cop-out. This would produce the ‘flexible inflation targeting’ framework that has backfired so badly for the US; it would legislate an inflation bias into the performance of the Bank of England and the ECB.

Raising the numerical value of the inflation target would in all likelihood shift the medium-term and long-term inflation anchor (wherever that is now) up by the same amount as the increase in the target, thus producing an equal increase in actual inflation without benefits for real activity.
Core inflation, the inflation rate of a bundle that excludes food and energy (sometimes other flexible-price commodities as well) is useful for monetary policy only if either people don’t eat, drink, drive cars, heat their homes and use air conditioning, or if core inflation is a superior predictor of future headline inflation over the horizons that the monetary authority can influence headline inflation – a better predictor not only than headline inflation itself, but than any readily available set of predictors. After all, the monetary authority should not restrict itself to univariate predictor sets.

Non-core prices tend to be set in auction-type markets for commodities. They are flexible. Core goods and services tend to have prices that are subject to short-run Keynesian nominal rigidities. They are sticky. The core price index and its rate of inflation tends to be less volatile than the index of non-core prices and its rate of inflation, and also than the headline price index and its rate of inflation.

However, the ratio of core to non-core prices or of the core price index to the headline price index is predictable, and so are the relative rates of inflation of the core and headline inflation indices. The phenomenon driving the increase in the ratio of headline to core prices in recent years is well-understood. Newly emerging market economies like China, India Vietnam have entered the global economy as demanders of non-core commodities and as suppliers of core goods and services. This phenomenon is systematic, persistent and ongoing.

When core goods and services are subject to nominal price rigidities but non-core goods prices are flexible, a relative demand or supply shock that causes a permanent increase (decrease) in the relative price of non-core to core goods will, for a given path of nominal policy rates, cause a temporary increase in the rate of headline inflation, as well as a temporary reduction in the rate of core inflation. So if you plot the difference between the headline inflation rate and the core inflation rate on the vertical axis against the rate of headline inflation, as I have done for the US in earlier blogs, you get a distinct positive association.

Therefore, when there is a continuing upward movement in the relative price of non-core goods to core goods, core inflation will be poor predictor of future headline inflation for two reasons. First, even if headline inflation were unchanged, core inflation would, for as long as the upward movement in the relative price of non-core goods continued, be systematically below both non-core inflation and headline inflation. Second, for a given path of nominal interest rates, the increase in the relative price of non-core goods will temporarily raise headline inflation above the level it would have been if there had been no increase in the relative price of non-core goods to core goods. When the increase in the relative price of non-core goods comes to a halt, headline inflation will not decline below the level it would have been at without the increase in the relative price of non-core goods. It would take a reversal of the increase in the relative price of non-core goods for headline inflation to fall below the path it would have been on in the absence of the increase in the relative price of non-core goods.

It’s time for central banks to put their money where their mouths have been for too long. In the words of that well-known monetary economist, E. Aaron Presley: “A little less conversation, a little more action please”. It’s time to fight headline inflation and squeeze that nasty genie back into the bottle.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website