Humbled central bankers scale back ambitions as inflation bites
NEW YORK: Once seen as the world’s go-to economic crisis fighters, central bankers are now desperately trying to contain a problem they allowed to happen: inflation. That’s eroded their credibility in the eyes of investors and society at large.
Officials have offered mea culpas. US Federal Reserve Chair Jerome Powell acknowledged in June that “with the benefit of hindsight, clearly we did” underestimate inflation. Christine Lagarde, his counterpart at the European Central Bank, has made similar concessions, and Reserve Bank of Australia Governor Philip Lowe said in May that his team’s forecasts had been “embarrassing.” In October, South African Reserve Bank Governor Lesetja Kganyago warned at a monetary policy forum that it takes a long time for central bankers to build credibility—but that it can be lost abruptly.
Central banks’ independence is harder to justify after such a failure of “analysis, forecasts, action and communication,” Allianz SE’s chief economic adviser, Mohamed El-Erian, tweeted in October. The tragic result, he says, is “the most front-loaded interest-rate cycle that we have seen in a very long time, and it didn’t need to be.”
The first step for the newly humbled monetary policymakers is getting prices back under control without creating economic havoc. Next they must transform the way central banks operate. For some experts, that means three things: paring down their mission, simplifying their messaging and preserving flexibility.
“Do more by trying to do less” is how former Reserve Bank of India Governor Raghuram
Rajan describes his advice to central bankers.
The Fed’s big miss on inflation has led Powell to start invoking the lessons of Paul Volcker, who famously tamed it in the 1980s.
Since Volcker stepped down in 1987, the Fed’s remit has expanded. Alan Greenspan, chair until 2006, rode a boom in productivity to even lower inflation, but also stepped in to support markets whenever there were threats to the economy. When reckless lending eventually blew up the housing and credit markets in 2008, thenchair Ben Bernanke deployed the Fed’s balance sheet in ways that hadn’t been seen since the Great Depression.
Coming out of the covid-induced recession, it looked as if central bankers had pulled it off again, led by Powell. Their coordinated response in March 2020 put a floor under asset prices and kept bond yields low, helping governments fund the massive spending needed to support millions of unemployed people. With inflation still tame, central bankers assumed responsibility for tackling problems such as climate change and inequality—
including setting a new goal of “broad-based and inclusive” employment. Meanwhile, stocks, bonds and cryptocurrencies were racing higher. Then consumer prices did, too, and central bankers didn’t see it coming.
The Fed’s new policy framework prevented a more aggressive approach to inflation, says Carl Walsh, a University of California at Santa Cruz economist who previously worked at the Federal Reserve Bank of San Francisco. He quotes the Federal Open Market Committee’s own words, which admitted that goals such as inclusive employment can shift over time and be tough to quantify.
“Making policy decisions ‘informed’ by employment shortfalls from a goal ‘that is not directly measurable’ has the potential to impart an asymmetric, inflationary bias in policy,” Walsh says.
Rajan says central bankers simply lost sight of their primary role, which is maintaining price stability. “If you told them, ‘That is your job, focus on that and leave all this other stuff aside,’ they would do a better job,” he says.
Monetary policy works through central bankers’ manipulation of points along the yield curve—essentially the price of money over different periods of time. Central bankers provide signals about whether to expect interest rates to rise, fall or trend sideways, and traders in the financial markets buy and sell vast quantities of bonds accordingly. Those moves percolate through the broader society, influencing pension account balances, business and consumer confidence and views on future price movements. That’s what determines whether the central bank policies work or not.