By Charles Goodhart, Emeritus Professor in the Financial Markets Group, London School of Economics, and Manoj Pradhan, Founder, Talking Heads Macroeconomics. Originally published at VoxEU.
The current mini-surge in inflation is forecast to return to central bank targets towards the end of 2022, or shortly thereafter. However, there is also a risk of inflation remaining persistently high for longer. This column discusses the implications of such a contingency for central banks and monetary policy. The authors warn that sudden policy reversals could lead to severe downturns in financial markets and significantly damage public sector balance sheets. Instead, they call on central banks to develop concrete plans for dealing with persistently higher inflation, with a particular focus on their balance sheet policies in a world of rising nominal interest rates.
At one point during the ECB’s recent Sintra Conference, a prominent central banker spoke about ‘longer-lasting transitory factors’; meanwhile, the adjective ‘transitory’ is becoming replaced by ‘temporary’. Although central banks have slowly and painfully been giving ground on forecasts both for the scale and duration of the current mini-surge in inflation, they, and most mainstream economists, remain in denial that it could become a more persistent feature of future years and decades. Inflation projections have been ‘marked to market’ to reflect the higher inflation prints we have seen, and some persistence has now has also been added. However, inflation is still forecast to return to central bank targets towards the end of next year, or shortly thereafter. In other words, it is still ‘transitory’, just for a bit longer (Ha et al. 2021). Let us fervently hope that they are right.
But what if they are wrong? What might happen if, say by mid-2022, there is little sign of inflation retreating from its end-2021 levels (of about 4-5% in Consumer Price Index (CPI) for all of the US, UK, and EU), with expectations of future inflation trending slowly up at all horizons, continuing shortages of labour, and workers, even where there are no shortages, demanding higher pay to compensate for both past and expected future inflation (e.g. Voinea and Loungani 2021, Ball et al. 2021).
Would it then be right to leave real interest rates at significantly negative levels, with unemployment trending downwards (who knows what the equilibrium natural rate might be), a growing need for infrastructure and green investment, and public sector deficits still historically elevated? Financial markets are currently expecting the Federal Reserve, for example, to start raising policy rates as early as September 2022, with four or five hikes of 25 basis points over the course of 2022-23. Breakeven inflation rates (the difference between nominal yields and inflation-protected securities) in the US at the five-year horizon are hovering around 2.7% (note that the two-year breakeven rate is higher, not lower, than the five-year, so we are being conservative with our measure of expected inflation). So markets appear to be comfortable with the real policy rate remaining persistently negative over the next few years.
So how will central banks react if, and when, they begin to discover that their forecasts and models have been systematically wrong? The most worrying possibility is that central banks might reverse policies suddenly and dramatically, with a 180-degree course correction entailing 50 basis point hikes and shrinking balance sheets. One can see only too easily how this might happen. After months, some of us might say years, of getting forecasts and policies wrong, central banks might feel that their credibility is at stake. Having stated that they were supremely confident in their ability to control inflation, they might feel forced to try to demonstrate that capability quickly and suddenly. What this might mean in practice could be a rapid shift from a policy of glacially slow increases in nominal rates, plus a very slow taper of quantitative easing (QE), to one of increases in nominal interest rates of, say, 50 basis points per meeting, and no replacement of maturing central bank holdings of QE-related debt.
But such a sudden shift of policy would be horrendously risky. Such monetary tightening would likely cause a rapid collapse in asset prices, including bringing to an end the world’s most coordinated housing boom. In view of the additional debt and high leverage of the private non-financial corporate sector, it could cause a steep rise in bankruptcies and non-performing loans (NPLs). We could get a depression of an awe-inspiring scale. The effect on the public sector balance sheet would be devastating. Tax revenues would fall, while public sector expenditures and debt service would rise sharply.
Under these circumstances, there would be no advantage or case at all in reversing course so sharply that inflation became replaced by deflation. There are many worse outcomes than a few years of moderate inflation, say in the 4% to 5% range. Even if central bank credibility takes a knock, one could always blame unforeseen events and/or the policies of predecessors.
So what should central banks now do against the possibility that moderate inflation becomes more persistent and increasingly engrained in the system?
The first need is to have a plan about what one might do under such circumstances, even if such a scenario is still thought unlikely. The Bank of England is to be greatly applauded for having worked out such a plan, and it makes sense. Indeed, it would be good to start putting that plan into operation, with a symbolic tiny increase in nominal interest rates in the immediate future.
Next, central bank economists need to start thinking about the effect of rising nominal rates, at the same time as real rates remain strictly negative. With higher and more persistent inflation, it will take some time for a slow increase in nominal rates to bring real rates back to zero; but rising nominal rates on their own will have significant effects not only on financial markets, but also on the real economy. In these conditions the concentration on r* is misplaced. The rate of change of nominal interest rates will be an important factor affecting the economy on its own, even when real rates remain strictly negative.
In addition, central banks may find themselves having to think harder and quicker about their balance sheet policies, and the form of their monetary operations (see also Cecchetti and Tucker 2021).
A floor mechanism for setting interest rates, plus quantitative easing, had many advantages during the years after the Global Crisis. Not only was it easy to manipulate, but it provided commercial banks with a huge buffer of liquidity, thereby making them much more resilient in the face of the Covid-19 shock. But when nominal interest rates start to rise, the disadvantages, in some large part political, of this technique will become increasingly apparent. At a time of worsening debt service ratios, the need for increased taxation and the transfer of increasingly large payments from the public purse to commercial banks for holding reserves at the central bank will become increasingly politically unpopular, not to mention the adverse effect on central bank profitability. You do not have to be a populist politician to see how this conjuncture could become widely unpopular, and difficult to defend.
So, central banks need to consider what their balance sheet policies should become in a world of rising nominal interest rates, and whether the current structure of quantitative easing and the massive availability of additional liquidity is still going to be optimal in such a different situation. First, central banks will have to bear capital losses on their holdings and could need recapitalisation from governments. That process will have to be structured in a way that does not raise questions about central bank independence (see Allen et al. 2021). Second, many of the quasi-fiscal uses of quantitative easing (such as propping up mortgage-backed securities (MBS) markets when they had assumed macroeconomic importance) will have to be unwound. Finally, over a structural horizon, as age-related government debt rises, central bank balance sheets are more likely to expand than shrink. The balancing act will be about avoiding the creation of moral hazard by monetising too much of the debt, versus doing so little that markets push interest rates higher because of concerns surrounding the financing of this debt.
And, through all of that, central banks need to pull these policies together in a way that convinces financial markets that an orderly evolution is not just possible, but likely. In other words, fighting the right war is difficult enough. Fighting the last war would be a catastrophe.
References available at the original.
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Inflation isn’t linear. Not sure what fantasy-land these authors live in where a central bank can sit back and do nothing while staring at a parabola.
Boiling frog, cooling frog. And no one is the wiser. ;>)
With all the gambling up of asset prices fueled by debt and having caused the price of living and working to go up and up and the ability of most to afford anything to aide in reducing carbon footprints to go down. with local politicians borrowing on behalf of their electorate instead of floating bonds and getting over indebted and super fragile in the process — to the benefit of the 1% – well of course an article will come out in favor of the FIRE sector and their conjoined twin the 1% to protect their turf at the expense of everyone else =
The best way to rob a government is to own it.
Debt that can’t be paid, will not be paid.
Jefferson had a bunch to say —
“If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”
“I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.” –Thomas Jefferson to John Taylor, 1816. ME 15:23
“Everything predicted by the enemies of banks, in the beginning, is now coming to pass. We are to be ruined now by the deluge of bank paper. It is cruel that such revolutions in private fortunes should be at the mercy of avaricious adventurers, who, instead of employing their capital, if any they have, in manufactures, commerce, and other useful pursuits, make it an instrument to burden all the interchanges of property with their swindling profits, profits which are the price of no useful industry of theirs.” –Thomas Jefferson to Thomas Cooper, 1814. ME 14:61
No wonder that Jefferson’s statue became radioactive and had to be removed. /s
The Fed has been taking about targeting inflation for years. It’s time for Powell to announce “Mission Accomplished”.
Czech National Bank hiked recently by 75bp. No-one expected them to, there were screams for the ministers (it was just before elections) and in general it was a YUUGE THING.
We’ll see how it goes the next time, but in the meanwhile:
– Skoda (one of the largest employers, and source of many good jobs) said for the first time I can remember they may actually fire some workers as opposed to just let the attrition take its toll (which IIRC was the 2007-2008 strategy).
– that would have huge impact not just on Skoda, but elsewhere, as there are many small/medium sized sub contractors providing services to Skoda
– the gas and electricity prices seen doubling, and for some people quantupling, their energy price. VAT will be suspended on it for two months till the end of the year, but it’s still going to make a large impact
– The RE prices were at all time high this summer. The mortgages, in the meanwhile, gone up from less than 2% pa to 3pa, and are forecasted to be at 4pa by the end of this year. That’s doubling of interest part for those who will need to refi, and of course double the interest expense for all new buyers. That’s on prices that few first buyers can afford now. The build prices, both labour and materials, are through the roof as well.
The whole situation just screams “recession”, possibly with high inflation.
Any calls for austerity yet? Yeah, it is a total disaster of a policy but I wonder how many governments will resort to it to par back public spending.
Austerity will only work in culturally united nations whose populace trust their their Establishment—see Japan, Korea, PRC, Taiwan, Sweden, Norway, Denmark, AUS, NZ. The UK barely scraped by the last round of austerity.
The US Establishment (DC Dems) would get thrown out in the next election if something along the 80’s Volcker shock happened here.
It will I think, if it hasn’t already become a UK thing – to hell with what Theresa May said. Maybe they will toast it’s revival with a nice chianti.
Inflation is not as much a banking problem as it is a scarcity problem. Eliminate the scarcities and you eliminate the inflation.
Today’s scarcities are with food, energy, and to some extent, computer chips. The central government needs to spend more, not less, to support the food, energy, and chip industries.
Don’t rely on the central bank to cure scarcities.
Inflation is a scarcity problem. Yep, that is what I was taught too in Econ 101. The more I learn about Economics the more I know I don’t understand it at all! But what I do know is that inflation isn’t a scarcity problem as much as it is a greed problem.
A couple of examples:
Housing in Boise: Boise is growing but not at the pace the housing and rent prices would suggest. Housing prices were going up after I bought my house 7 years ago. That was attributed to housing coming out of the slump it was in Boise. I know I was able to buy my house fairly cheap. Then in the last 2 years, Boise was ‘discovered’ and we started getting ads everywhere from corporations wanting to buy our houses an the price of housing skyrocketed. Investors would pretty much buy anything at any price.
Now it is only investors in Boise that can afford to buy a house. The inflation in housing prices has absolutely nothing to do with scarcity.
Hamburger:
I’m not a big meat eater, but I do like a little hamburger to add umami to some of my casseroles. When I moved to ND, a relative whose family has a ranch gives me hamburger from the ranch now – I don’t have to buy it. But what I found is that hamburger from the ranch has no water in it and so it goes MUCH farther. I don’t have to use as much because I am not boiling the excess water out of it any more. Is there any reason to load all that water into hamburger? So you are paying for water at the price of meat when you buy store bought hamburger. Doesn’t that inflate the price of your hamburger? That has nothing to do with scarcity.
I could give many other examples of where Econ 101 just doesn’t make any sense any more but then I don’t know what about Economics as a whole makes any sense for me any more.
Another neat trick is the way supermarkets have those mist nozzles soaking down the greenery in the produce department. “Lettuce, $2.29 a pound,” when there’s maybe an ounce or two of water drenching the leaves. The liquid-ity of inflation.
Much like the nominal ‘half gallon’ of orange juice that is now just 54 ounces, or the ‘6 ounce can of tuna’ called for in my mother’s tuna casserole recipe that is labeled “5 ounces’ but when you drain it, there’s maybe 3 1/2 ounces of actual tuna meat…
And what are we “consumers” supposed to do, when the food processors and market owners crap on us this way? Time for some autarky, maybe? However inconvenient it might be in the short term?
“However, inflation is still forecast to return to central bank targets towards the end of next year, or shortly thereafter.”
I have to laugh! Targets for inflation? Sure. If the Fed knew what they were doing and were not busy catering to the FIRE boys, things would be different.
Inflation is GREED any way you look at it.
Spend more? Spending INCREASES scarcities not reduces them.
Scarcities are fixed decreasing spending or producing more (often through investment) but that take years to change.
It depends on what has caused the scarcity. In the 19th century a year of scarcity was equally matched with a year of saving. Inflation of 20% was followed with a 25% deflation. This was usually caused by slow information exchange between buyers and sellers. It could take more than a year for markets to clear.
We arent in that situation. Information flows are immediate.
In the past there were economic shocks such as war and natural disaster. In this case, demand side policies (interest rates, tax, government spending, money printing) aren’t going to resolve the economic problems because the problem is supply related.
Pandemic could be considered a natural disaster. However, the pandemic didnt cause crop failures and the wind to stop blowing.
As a millennial family with significant student loans I welcome inflation. The unofficial nationwide strike is a godsent. I hope it continues and pushes wages higher. Inflation and wages rising in tandem for the next five years would significantly ease my families student loan burden.
Dontcha know that the inflation effects only ratchet one way? You really think wages are going to track upward, or that banks will lift the needle on interest they pay depositors off the 0,01% peg? Prices will go up, of course, until the gold standard is re-instituted, am I right? Or something like that…
It’s all about power, of course.
The gold standard won’t be reintroduced by government, but there are private currencies out there that are 100% backed by gold and one of them even pays a small yield (paid out of distributed transaction fees). It is a move away from debt money / debt based yields to allocated gold an utility based yield. This is the future.
The fiat system is basically bankrupt. Central banks and governments still think that they can create something out of nothing (or at least they prevent to believe that, because it benefits them personally). But the chickens are coming home to roost now and many people realise that now. But there are alternatives and people are embracing these now.
Good luck paying your taxes, fees and fines with that private currency of yours.
Good grief …
I do think that the days of banks paying decent interest are over, now that they can create money with a few keystrokes, without having to entice depositors. Even if loan rates go back to 10%, the rate paid to depositors will stay low.
…transitory…temporary…BS econ tawk.
…markets appear to be comfortable with the real policy rate remaining persistently negative over the next few years...econ tawk. Lemme translate this into serf tawk…the plutocrats and the ruling class are happy to continue using money for free forever.
The consumer price index…would that be the CPI whose core inflation omits prices of food and energy? That’s OK. Pretty soon only the serfs will go hungry and will be sleeping in their gasless cars. And here we have Nabiullina citing rising food and energy prices and frantically cranking the Russian CB interest rate to 7.25% Maybe she should be authoring this piece.
“After months, some of us might say years, of getting forecasts and policies wrong, central banks might feel that their credibility is at stake.” Central Banks? Is he tawking about Corporate Bespoke Boutique Banks that slavishly support the three-home owning class worldwide? Just say it pal.
“A slow taper of QE…” Geez, no more Bespoke buying of crappy debt for corporate use to buy crappy equity and jack stock prices. And a .50% raise in the interest rates? Ack! Think of the adjustable rate mortgage on the third house. “…Horrendously risky...indeed.
Yah, time now for the really bad news...the effect on the public sector balance sheet would be devastating. Tax revenues would fall, while public sector expenditures and debt service would rise sharply. We really can’t let such a monumental crisis befall our poor states and municipalities. That’s economist tawk for “we care.”
“First, we need to have a plan.” So, they haven’t been carrying out the plan? Maybe the plan could begin with dismantling the monopolies and oligopolies that control every sector of society and suppress innovation, present barriers to entry, have total pricing power and influence over all public policy. After reading this crappy piece, I wanna hear from Elvira Nabiullina.
Lacy Hunt think deflation is the major thread.
No one really knows anything about economics.
https://hoisington.com/pdf/HIM2021Q3NP.pdf
Central banks have backed themselves into a corner with their poorly conceived policy decisions over the past decade plus. They are screwed, and so are we. Central banking needs to be completely overhauled, if not eliminated.
Am I wrong to think that perhaps the U.S. Federal Reserve has in fact been working tirelessly to further the interests of its Boards of Governors, which are loaded with private bank representatives?
That’s why it was formed. Its been going on for 100+ years, its only now getting ever more egregious. The Fed should be like FDIC insurance. You want to be able to borrow from the discount window at below market rates when/as needed and have the Fed step in and buy your crappy assets at full price to ensure your solvent: you pay for the privledge of this backstop
“…the world’s most coordinated housing boom…”
What is this creation; where may we see it, pray? Is it the shipping containers, mayhap?
You can call me an ignorant fool. I be that.
My tired eyes read ‘Sintra Conference’ as ‘Sinatra Conference’ and I immediately heard “I did it my-y-y-yy-y-y wayyyy…”
bye, have a nice evening, all, who knows what I’ll be seeing next
Central Bankers embrace a degree of groupthink about everything but especially basic economics.
Already, if Mr Market is demanding different interest rates or shrinking the sizes of our groceries or there’s inflation in car prices it is verry verry slow to register at the top of the opinion pyramids where we have sited our Central Banks.
But… if the economics of inflation control in a debt-laden and deflating consumer economy don’t work out – well, that would take a different set of committees that plain haven’t been invented yet, and more data too.
The curious use of abstractions to constrain their very thoughts could only be explained if we knew how they were brought up as children. Before they grew into committees.