Central banks and the return of inflation

Financial crises come in all shapes and sizes.  Some erupt seemingly out of nowhere – a bank that suddenly collapses, a stock market crash, a currency crisis.  One day all seems well and the next day … it isn’t, and the authorities are in full fire-fighting mode.  Over the last 10-15 years, central banks have had quite a lot of such fire-fighting episodes to cope with, and in general their speed of reaction to each crisis and willingness to be innovative in their responses has been impressive.

Other financial crises on the other hand display a much longer “slow burn”; they build slowly and gradually, with at first real doubt and debate as to what is happening, and realisation and acceptance only coming late on in the process (indeed sometimes only in retrospect).  Paradoxically, such crises can be much more challenging for the authorities: the long lead time may look like offering them time to prepare their defences and work out their strategies for combatting the issues, but in practice it merely allows them firstly to deny that the problem exists at all (let us call this Stage 1), then prevaricate and hope that the issue will go away of its own accord (Stage 2), then delay the necessary countermeasures while they debate how serious the situation is (Stage 3), and only then, very late on in the process, take the necessary action (Stage 4) – but by then, the action required to restore order is often both more extensive and harsher than it might otherwise have been.

It is becoming clearer by the day that the authorities’ current position over inflation in many western economies is following this four-stage playbook pretty closely.  The first signs of inflation returning were visible well over a year ago, with some economists warning as early as summer 2020 that ballooning money supplies would inevitably lead to sharper and more prolonged inflation in due course, and by now there can be few people who have not experienced the effects of price rises, often sharp price rises, in their daily lives – everything from fuel and energy to food and eating out to services in general seems to be getting much more expensive.   Inflation, for the man and woman in the street, is here, is high, and as more and more sectors of the labour force respond by seeking wage rises, is threatening to become entrenched.

And yet central banks, having spent most of 2020 in what in our taxonomy above we termed Stage 1 (“there is no risk of inflation”), and most of 2021 so far in Stage 2 (“the inflation we are seeing is transitory and nothing to be alarmed by”), are only slowly and, we sense, reluctantly, girding themselves to move to Stage 3.  And no major central bank has yet moved to Stage 4, no central bank has started actually to tighten monetary policy.  Most indeed are maintaining their aggressive monetary support for their economies through their various asset purchase programmes.

The Bank of England is typical of most major central banks in showing this reluctance to act:  the furthest they have been prepared to go is to say that inflation could mean that interest rates might need to rise next year[1].  “Next year”, note, not “now” or “might have been better to have started 3 months ago”.

This raises two questions.  Firstly, what is the outlook for inflation if central banks continue this delaying action, continue as it were to ignore the old proverb “a stitch in time saves nine”?  And secondly, why, when they are usually so well aware of the need to act pre-emptively (in central bank speak, “stay ahead of the curve”), are they so reluctant this time to take the necessary actions to ensure that the inflation we are all seeing and experiencing right now is kept under control?

My colleague Gabriel Stein has written recently on this, what he terms “the central bank inflation-fighting paradox” – see http://steinbrothers.co.uk/the-central-bank-inflation-fighting-paradox/.  As he observes, there is more at risk here than balancing the possibility of inflation being a percentage point or so higher next year against growth being a percentage point or so lower.

If that was all that was at stake, it might be legitimate to argue that all efforts should be made to keep the recovery from the pandemic-driven slowdown going, and that a bit more inflation is a price worth paying to achieve this – though such a stance is by its nature more of a political statement and we would expect it to be made by finance ministers rather than central bankers.

But that is not all that is at stake.  For if inflation genuinely catches hold – if for example wage rises start to be demanded and feed back into further cost pressures for businesses on top of the supply-driven cost pressures and higher taxation they are already facing – then at risk is both central banks’ reputations as inflation-fighters and also their very real achievement of changing the public’s mindset and inflation expectations.

Although it is perhaps hard for those under the age of say 50 to remember it, and for anyone under say 40 even to imagine it, the norm for the latter part of the last century (say 1960-1990) was that the public both generally expected and feared inflation.  It loomed large in both political discourse and labour relations, and few companies made major long-term decisions without bringing it into their planning process, at the cost of effort, time and money  that could have been used for more productive purposes.   It took central banks many years and much effort to change these public perceptions on inflation to the position of the last 25 years or so, where for most people inflation has been a minor irritant rather than a serious issue or concern.

If we return to a world where people generally expect inflation and act on those expectations, then it will undo all the good work of central bankers in making inflation unimportant (in central bank speak, “a world where inflationary expectations are anchored” – anchored, that is, around very small numbers), and we risk returning to the situation we faced in the 1970s and 1980s, where people tried to pre‑empt inflation and protect themselves from it by demanding large pay rises, and therefore fuelled the very inflation they feared.

So, why are central banks taking this risk?  One element might be the usual dilemma that if they take unpopular action – raising interest rates, for example – and as a result successfully keep inflation very low, they are open to the accusation that they over-reacted and caused the economy unnecessary harm.  When preventative action is successful, and prevents a problem emerging, it is often quite difficult to prove that the problem was real and the painful action necessary and justified, and central banks are always open to the criticism “Inflation?  What inflation?  Why did you raise interest rates and kill the economy?”

But that has always been the case, and has not stopped previous generations of central bankers from acting when they needed to.  So what is different now?  Even if they genuinely believe (rather than just hope) that the current inflation is temporary and will evaporate without them needing to do anything, one might have expected central bankers to want to play safe, to take steps to protect their reputation, to stay ahead of that curve they always talk about.

And the uncomfortable thought arises – uncomfortable for central bankers – that taking action against rising inflation might in fact be more risky not less to their reputation and standing than their current inactivity.

This needs unpacking.  While in public central bankers like to portray an aura of all-knowing infallibility, most know that inflation is a more complex phenomenon than the general public understanding of it would suggest, and in private many admit that there remain parts of the inflationary process that are not perfectly understood.  Nor are the dynamics of inflation constant, so that what worked for them 10 years, 20 years ago may not continue to work now, or may need to be changed.

The result is that central bankers are much more modest in private discussions about their inflation-fighting abilities than they are in their public pronouncements, and have less confidence than the general public in their ability to control inflation.  They know for example that the benign low-inflation environment of the period from 1993 was only partly their doing;  the so‑called NICE or “Non-Inflationary, Continuous Expansion” decade (a phrase coined by Mervyn King when he became Governor of the Bank of England in 2003) was as much due to events outside central bankers’ control, like the emergence of China as a major trading nation, as because of anything they themselves did.

This element of self-questioning has latterly morphed closer to self-doubt, as they have been both surprised and perturbed by their failure to generate inflation over the last few years.  In the latter part of the 2010s, the big fear in central banks was of deflation, and they made huge efforts to generate more inflation to get headline figures up closer to their 2% targets – their failure to do so was not much noticed by the general public, for whom the difference between 1% and 2% inflation was unimportant, but it worried central bankers, not least because it showed that their understanding of how inflation works was incomplete[2].

And so to today.  Central banks are still on the whole perceived by the public to be “good at controlling inflation”;  this credibility is valuable and a major contributor to their overall reputation and effectiveness, and if people lose faith in their central bank it can be extremely damaging.  And a quick way to endanger that credibility would be to take overt steps to counter the inflationary threat and find that they were not effective.

In short, central banks are not 100% confident that if they did act, it would work.  And if it did not work, the damage to their reputation and so long-term effectiveness might be substantial, more even perhaps than the damage of slightly higher inflation.

The saying that “It is better to have tried and failed, than to have never tried” is such a popular one in its various forms that it has been ascribed to any number of people, from Alfred Lord Tennyson to Teddy Roosevelt and many others besides.  It is without doubt a glorious sentiment, but perhaps central banks may be forgiven for paying at least as much attention to the more prosaic but perhaps more practical saying “Live to fight another day”.

And for the rest of us, it is beginning to look as though alongside the mantra about interest rates being “lower for longer”, we might have to get used to inflation being “higher for longer”.


[1]              “If the economy continues to recover, and inflation shows signs of being more persistent, then it might be right to think of interest rates going up in the next year or so” – Michael Saunders, MPC member, 7 September 2021.  And “… there may need to be some modest tightening of policy to be consistent with meeting the inflation target sustainably over the medium term” – Andrew Bailey, Governor, 26 September 2021.

[2]              This is not entirely surprising:  as we have observed, economies change, as do the mechanisms and relationships within them, and our understanding of inflation needs to change with them.  This is not easy, and central bankers are just as susceptible as army generals to the tendency to fight yesterday’s war.  But it also reflects a more specific reluctance by modern central bankers to accept that “inflation is a monetary phenomenon”;  that is, that an aggressively expanding money supply today heralds higher inflation in the future.  That this basic tenet of monetarism – the orthodoxy of say the 1980s – is now so firmly out of favour amongst leading central bankers is slightly more surprising; but if your crisis-fighting weapon of choice is asset purchases, which by their nature involve massive money creation, it is probably beholden on you to deny the unfortunate side-effects of your new miracle weapon.