Do Central Banks understand inflation?
Commentary by Kathleen Tyson - September 28, 2022
Professors Charles Goodhart (a Pacemaker Advisor) and Manoj Pradhan are warning again that inflation is likely misunderstood, characterising three very different views of inflation now current, only one of which can be correct: Inflation: What Went Wrong, and Why? They summarise the three as the 'authorised' central bank view of inflation (reverting to lower for longer); the Summers/Blanchard analysis (excess fiscal and monetary laxity accelerating inflation); and the Goodhart/Pradhan argument that inflation is systemic and accelerating due to factors beyond central bank control (demographics). They see stagflation as the most likely outcome as central banks will not be allowed to raise rates enough to curb inflation in the face of unserviceable debts and slowing growth.
So, what do we think will happen? Our best guess is that nominal interest rates will have to move up to around 3.5–4% to have a significant effect in softening labour market tightness. By then, a combination of asset price declines, falling employment and output, and sharply worsening fiscal conditions will lead to strong media, public and political opposition against any further rate increases. More weight will be placed on direct price controls. Central banks will settle for an inflation rate of around 3.5% in these circumstances. Perhaps the main problem is that the fiscal position has been allowed to drift so far that a recession caused by monetary tightness has become unacceptable. But as the availability of labour remains tight over coming decades, and dependency ratios worsen as populations age, the underlying context will remain inflationary, not disinflationary as the mainstream still believes.
With uncanny timing, the Bank of England stepped in to support bond markets today after gilts shot over 5%. QT will be delayed at least a month, if it happens at all. Markets are breaking. Bank of England Statement 28/09/22.
Central bankers have admitted that they do not understand inflation. At a panel this summer Jay Powell, Christine Lagarde, Andrew Bailey, and Augustin Carstens all admitted that their predictive models and panels of forecasters had been persistently inaccurate. We should pay attention when they admit collective failure as it is a rare event. Yet none calls for a rethink of central bank tools, as admitting permanent shift from the familiar models creates more risk of loss of public confidence.
Goodhart and Pradhan were way ahead of the curve in identifying a shift in the inflation dynamic when they published their book, The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival in the summer of 2020. They deserve great credit for being brave enough to challenge their peers and call the turn on the low inflation past.
This original and panoramic book proposes that the underlying forces of demography and globalisation will shortly reverse three multi-decade global trends – it will raise inflation and interest rates, but lead to a pullback in inequality. “Whatever the future holds”, the authors argue, “it will be nothing like the past”.
At the time the vast majority of economists foresaw a future of low interest rates, low wage pressures, abundant credit and liquidity, and a quick recovery from the pandemic storing trend growth. Charles disagreed, seeing high, sustained inflation and economic stagnation - stagflation - as the most likely outcome.
The quote below is from the interview Charles gave when receiving a Lifetime Achievement Award:
But with a smaller proportion of workers to an increase proportion of aged, it means that if we’re going to pay the same benefits to the old like me, the workers like you are going to have to be taxed more. The thing is, people don’t like being taxed, and it’s politically unpopular. Well, then, if we are going to have continuing primary deficits as far as the eye can see, inflation starts rising. You can then have much tougher monetary restrictions through interest rates. But that’s not popular, either. It’s not popular to people with mortgages: it will cause financial markets to swoon. You might even get a financial collapse, and could even have a recession, which doesn’t do anyone any good. And that’s the sort of reason why, under these kinds of pressures, the independence of central banks may come under threat. So, in many ways, it is actually harder to restrain inflation now – the debt ratios are two or three times what they were when Paul Volcker was doing it. This means the complications of raising interest rates are now that much greater. This is one of the reasons why we think that the political outcome is going to be more inflation, which is a way of reducing debt levels in a somewhat underhand manner.
Read the whole piece for more insight:Charles Goodhart on inflation targets, financial stability and the role of money.
I would add that globalisation, dominant currency pricing and debt in dollars and euros, lack of liquidity in wholesale funding and collateral assets, and a host of other factors have skewed the inflation challenge for most countries. While the debt crisis of the 1980s was most harsh for developing economies, the debt crisis coming now will take OECD countries into turmoil as well.
We see this already in the UK in the dramatic market events of the past week. More on that in my next post which will look at the unprecedented moves.