As central bankers met in New York this week for the annual meetings of the International Monetary Fund and World Bank, one question above all was on their minds: what the hell’s happening?
The global economy is built around the consensus that the best way to deliver solid and stable growth is via solid and stable prices. Keep inflation in good order, and the rest takes care of itself – give or take a financial crisis or two.
Yet as Chris Giles of the Financial Times noted this week, central banking is undergoing a “crisis of confidence”. The heart of the problem is the inflation rate, which isn’t behaving as it should. Even as more and more jobs are created, wages remain stubbornly low – because inflationary pressures aren’t feeding through as they should. Inflation might be, always and everywhere, a monetary phenomenon. But the advent of QE appears to have scrambled the signals.
Giles’s piece goes into a variety of reasons why this might be the case, ranging from there being more slack in the economy than was previously thought to the idea that a low-inflation environment has bred an expectation of further low inflation: in other words, we aren’t asking for pay rises even though we should be.
The upshot is that central bankers are essentially flying blind, unsure whether they should be shovelling more coal into the economic engine or trying to cool things down.
So when Janet Yellen warns that “our framework for understanding inflation dynamics could be mis-specified in some fundamental way” – or her predecessor Ben Bernanke suggests that the inflation target should be abandoned in favour of a price-level target, at least when interest rates are so low – what they’re actually saying is that we’re all in big trouble.
But there’s a further, and equally alarming, point – one which was made to me by a central banker recently.
I’d launched into the standard tirade against QE for stoking an asset price bubble and thereby widening the gaps in society (for example, helping house prices to surge out of the reach of the young).
Yes, he said, I had a point. But he and his colleagues could not do anything about it. Under the terms of central bank independence, as established in most Western countries, the prime directive is to hit the inflation target. That’s why the annual letter from the UK Chancellor to the Bank of England, setting out its remit, leads on “the primacy of price stability and the forward-looking inflation target”. The Federal Reserve similarly stresses that aiming for that same 2 per cent inflation target “is most consistent over the longer run with [its] statutory mandate”.
This leaves us in a gloriously problematic situation. Central bankers are increasingly aware that the levers they’re trying to pull aren’t having the expected results – and are increasingly alarmed about the fact. Yet they are legally mandated to keep pulling those levers. Yes, they can scour the economic instrument panel for indicators that might be more accurate or more useful. But when it comes down to it, they have to keep their eyes primarily focused on the blurry, flickering and possibly malfunctioning gauge labelled “inflation”.
It may be that, as central bankers slowly hike interest rates back up into the “normal” range, and gradually wind down quantitative easing, normal service is restored. But if it isn’t, then the people guiding our economy – and the politicians who set the terms under which they operate – are going to have some very serious thinking to do.
This article is taken from Robert Colvile’s Weekly Briefing email for CapX. Sign up here.