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Inflation is not the only demon


Edward Price is a former British economic official and current teacher of political economy at New York University’s Center for Global Affairs.

As central banks attempt to tackle this global inflationary spiral we should ask ourselves a very simple question. Worried inflation-targeting central banks now only care about inflation targets, right? Wrong.

Look no further than the European Central Bank. Last week, the ECB confirmed its intention to raise interest rates by 25 basis points in July. On the face of things, this is good. In May, consumer inflation in the 19-member euro zone hit a record 8.1 per cent. That is not so good. In fact, that is très mauvais. Bringing this upward price pressure under control is now Christine Lagarde’s number one concern.

But it is not her only concern. Check out Martin Arnold’s succinct expression of the ECB’s other fears in the FT:

. . . the ECB . . . [is] hoping to regain control of prices without tipping the economy into recession or triggering a bond market panic in the more vulnerable countries of southern Europe.

This smells a bit like 2010 doesn’t it? Yesterday, for example, the ECB announced a new “anti-fragmentation instrument”. That probably means more bond buying, which, in turn, would mean anything but an anti-inflation instrument. And earlier this week, M&G Investments’ Eric Lonergan predicted that the second euro crisis has now started.

So yes, today’s central bankers fret about inflation – as the Fed’s decision yesterday to lift rates by a whopping 0.75 per cent underscores. But they are also fretting about whether and why their economies are in equilibrium and whether and why their financial systems (and currencies) are sound.

The question is how aggressively monetary policy should intervene to dampen prices in the face of supply shocks, the duration of which are unknown. This is tough. How far monetary authorities should allow any economy to adapt to new global circumstances is unclear if, in turn, those new global circumstances are themselves unclear. Perhaps Ukrainian special forces now have more influence on monetary conditions than any central bank.

It’s a tricky balancing act. Moreover, an inflation-targeting central bank’s tools are not always pointed at prices anyway. We could say that policy innovations after 2007-8, including the 2020 pandemic response, deviated from strict inflation targeting.

For the best example, take quantitative easing (QE), which initially aimed at providing the financial system with ample liquidity and exploded central bank balance sheets the world over. Behold, the total assets of the Federal Reserve System.

At least there is some room for non-inflationary concerns. Today’s policymakers don’t face the inflation problem of the 1980s (see here for Nick Peterson’s take on the Volcker mythos). But, in fighting now-rampant inflation, they will have to worry about the novel side-effects of rate hikes on nervy financial markets and pallid economies. This is, after all, effectively wartime.

The wider point is that central banks make judgment calls. And while inflation may be the main policy concern at the moment, it is far from the only one. Finding the balance between all of them is probably impossible to get exactly right.

As central bankers have hinted in recent years, even knowing what exactly to calculate, measure or model is never easy. In 2018, at Jackson Hole, Powell had said this to say about the bread and butter of economics, the natural levels of things like unemployment and interest rates also known as the stars:

Navigating by the stars can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging . . . because our best assessments of the location of the stars have been changing significantly.

The Fed chief was hinting at two open secrets. One, whether any given economy is running in an optimal way is, erm, unknown. Two, what policy should do in response to apparently suboptimal outcomes is, erm, also unknown. Even for those of us who warned inflation was going to be a problem (yes, Larry Summers, you win macro), who’s to say that wasn’t just a guess? No one. Now the reality of ex ante macro uncertainties are becoming clear in the reality of ex post inflation.

So, spare a thought for the ECB, the Fed and other inflation-targeting central banks. The reality is that they are not only targeting inflation. And they are not doing so because we do not want them to target only inflation.

Instead, we have asked them to spare us price pressures while also asking for guaranteed growth. We have asked them to avoid market meltdowns, while also asking for happy currencies. We have, in essence, spent 35 years asking our central bankers for an upside without expecting a down.

Perhaps central bankers shouldn’t have listened. But now the bill is due, we shouldn’t also ask them to shoulder all the blame. Price stability is dead. And we killed it – you and I. 


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