Central bankers’ bubble is burst by inflation
The era of policy dictated by unelected financiers is unlikely to survive the economic damage wrought by the pandemic
In the memoir Paul Volcker wrote in 2018 shortly before his death, the former chairman of the US Federal Reserve asked a good question about inflation. “How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?”
What Volcker was criticising, in Keeping at It: The Quest for Sound Money and Good Government, was the obsession of his successors, in the US and globally, with the idea that hitting a target on inflation was the key to prolonged economic success.
If central bankers adjusted their policies on interest rates so that inflation always stayed close to a target of, say, 2 per cent, then markets would have certainty and stability in which to operate. Growth and high employment would generally follow.
That was the questionable theory that has dominated central bankers’ thinking since the 1990s. But the latest inflation figures show it isn’t working: we have hit 5.1 per cent in Britain and are heading for 6 per cent; the eurozone was at 4.9 per cent last month; and in the US inflation is already at 6.2 per cent.
With inflation-targeting failing, central bankers have very publicly lost control. For months they told us that inflation was “transitory”, but transitory has turned out to mean sustained and, for now at least, rising.
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Back in the 1990s, the concept of narrow inflation-targeting was appealing to both politicians and voters: central bankers seemed to have found the potion for perpetual prosperity. The theory underpinned global policy under Volcker’s successor, Alan Greenspan, who was treated as something like a rock star by politicians during his five terms in post.
In Britain, New Labour gave independence to the Bank of England in 1997 so that self-interested politicians would no longer be able to interfere in setting interest rates. The central bankers would ensure the economic cycle could be smoothed out, lowering rates and pumping in liquidity at any sign of trouble, thus ensuring an “end to boom and bust” as Gordon Brown put it, hubristically.
That went wrong with the financial crisis in 2008, then in the eurozone crisis that followed. It turned out that other risks such as too much debt could still build up and disrupt the economy.
Weirdly, central bankers did not lose authority or get much blame when that happened. In the US, the eurozone and the UK they acquired even more power, instigating quantitative easing (QE), the so-called money-printing project designed to keep the show on the road.
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The philosophical inspiration for all this was Greenspan. The thinking — noble in a way but delusional — was that central bankers would do whatever it took and the rest of us could be reassured they had the answers. But the QE policy distorted economic incentives and divided society, rewarding those with existing assets. It even fuelled a cheap money property boom that accelerated during the pandemic.
Now, no one seems to know quite what to do next and the consequences for politicians are serious. That is less a criticism, more a simple statement of reality. The situation is highly complex, difficult to manage and fraught with more risk than usual, because of the complications of the pandemic.
Right now, interest rate rises that will make borrowing more expensive are clearly required if we are to at least attempt to tame rising prices. Reducing the appetite for consumer and business borrowing lowers inflation.
Or rather, it does usually. This time it’s unclear to what extent raising rates will make a difference. Soaring prices may have more to do with supply chain disruption from the ongoing pandemic and the retreat from globalisation that made us overly reliant on long supply lines and shipping in cheap foreign goods.
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There are no simple answers to the problem and that’s what makes this situation so dangerous. Populations who feel themselves getting poorer become angry, looking to political parties that offer simple, populist explanations for what went wrong and who to punish.
There’s more to it than that, though. We tend to measure politics and public affairs in terms of short electoral cycles, from one leader to another. But history moves in much longer cycles. The central banker orthodoxy was born in the aftermath of the oil crisis in 1973 and successive bursts of inflation and painful economic reordering in the 1980s. Later, technology and globalisation kept prices cheap.
Now we are transferring from that economic era to another: from the epoch of confident, unelected central bankers to a time of turmoil, post-pandemic, in which politicians will want more control, to do goodness knows what, when voters are telling them they’re in pain.
We could do with someone as experienced as Volcker to help navigate this. He was in the room when President Nixon decided that the US dollar should come off the gold standard in 1971. As chairman of the Federal Reserve from 1979 to 1987, he wasn’t remotely relaxed about high inflation. On the contrary, his painful hiking of interest rates in the 1980s tackled the runaway inflation that had bedevilled the 1970s.
Volcker was a sceptic, wary of putting too much faith in central bankers and simple theories. In his memoir he was as interested in the necessity of good government, and the urgent need for sensible political leadership, as he was in sound money.
Now, we have neither good government nor sound money. If you thought the past ten years or so were tumultuous, get ready for even more trouble to come.
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