This past year has been the first time since the Bank of England was made operationally independent in May 1997, that monetary policy has been politically difficult. From a technical point of view, designing the right monetary policy has also been slightly more complicated than usual, but nothing that a bunch of moderately intelligent graduate students in economics wouldn’t be able to handle. The same applies to the ECB, which started functioning as the central bank of the euro area on January 1, 1999. The Fed has not gone through any institutional transformation since the Humphrey-Hawkins act of 1978, but it too has not been in the current painful policy position since the early 1980s.
So far, these three leading central banks have failed the test. They have looked inflation in the face, blinked and hoped for a better tomorrow.
There are two reasons things are slightly more difficult today from a technical perspective. First, a massive global liquidity crunch has forced all the leading central banks into lender of last resort and market maker of last resort mode, supplying the markets with unprecedented amounts and kinds of liquidity. The financial system and especially the banks, are fragile. Many banks will have to shrink the scale of their operations and balance sheets or go out of business altogether. Many financial markets remain closed for business. The monetary transmission mechanism is therefore likely to be working rather differently from the way it has been for the past twenty or so years.
Second, the global increase in food and fuel costs manifests itself to individual food and fuel importing countries as a one-off increase in the general price level and an increase in the relative price of imported non-core goods to domestically produced core goods and services. This is a double adverse supply shock, the first temporary, the second permanent.
This double supply shock is uncommon rather than hard to handle: you don’t try to reverse the one-off increase in the general price level. You watch out carefully for second-round effects and tighten when they show up. You tighten monetary policy in response to the permanent increase in the relative price of food and fuel because this causes the path of potential output to be lower.
The Bank of England appears to ignore the reduction in potential output represented by the increase in the relative price of non-core goods to core goods and services. It also ignores (chooses to ignore) the evidence of strong second-round effects from recent increases in the general price level. Instead of responding to the clear evidence of higher inflation expectations, short-term and long-term, the Bank takes comfort from the fact that earnings growth or unit labour cost growth has not increased much. That may be a false source of comfort if, as I suspect is the case, the equilibrium share of labour in national income is still falling under the combined influences of globalisation and technical change. In that case there can be full translation of higher expected inflation into earnings growth and unit labour cost growth but no commensurate effect on recorded earnings growth and unit labour cost from one period to the next. Higher expected inflation does get translated into higher actual inflation (on the GDP deflator measure) , however, because the mark-up of prices on unit labour costs is rising – the other side of labour’s declining income share.
The Bank of England continues to sit on its hands, with CPI inflation now at 3.8 percent. At least real short policy rates are still likely to be positive in the UK. In the euro area, where the ECB is far behind the curve despite raising its official policy rate to 4.25 percent this month, forward-looking real policy rates may well turn out to be negative. In the US, the Fed is so far behind the curve that it is likely to look itself in the back sometime soon.
Central banks that raise rates to fight high, rising and above-target inflation at the same time that real output growth (and perhaps even the level of real output) is falling and unemployment is rising are unpopular institutions. Much more unpopular than when rates are raised at a time when inflation is high, rising and above-target but output and employment too are high and still rising. Ministers of Finance, parliaments and other political figures and entities are all over them. But these are exactly the times that independent central banks were made for. Apparently, formal operational independence is not enough. It is true that the Fed, with its dual mandate and its lack of formal independence has turned out to be the softest of touches for those who cry for help whenever a downturn or recession looms. But the Bank of England too appears to lack the courage of its convictions and the ECB is all talk and very little action.
This is your time, guys & gals. This is why central banks were made operationally independent. If you don’t use the political space created by the laws that granted you operational independence to keep the lid on inflation when this is difficult – as it is today – there is no point in granting central banks operational independence. Only determined action by central banks can put the inflation genie back in the bottle. Praying for a miracle won’t do.