There is an old joke about a man who gets lost in the countryside and asks a local for directions to the nearest town. The local responds: “if it’s the town you’re going to, I wouldn’t start from here.” In many ways that perfectly sums up the position central bankers find themselves in today. Inflation has ramped up in a way that was unforeseen just six months ago and as a consequence interest rates are currently too low for prevailing inflation conditions. It is a very uncomfortable place to be because it opens up central banks to the charge that they are behind the curve on policy.
Onwards and upwards
It is very easy to make the case that central banks missed the inflation surge and have maintained a lax monetary stance for too long. On a literal interpretation this is true. There again, the consensus forecasts did not anticipate the inflation surge either so the noisy brigade perhaps ought to dial down some of the criticism about how slow central banks have been to react. We can see this very clearly in UK data using consensus forecasts for CPI inflation in Q4 2021 against the BoE’s projections (chart below). If anything, the central bank anticipated the inflation surge slightly quicker than most forecasters.
Perhaps the criticism is rooted in the fact that central banks were tardy in tightening policy as the economy normalised following the GFC of 2008-09. I have a lot more sympathy with this view. There was no justification for maintaining the lax stance adopted in 2009 once the economy started to normalise and those criticising central banks today perhaps feared a repeat of the policy mistakes of the 2010s which promoted significant inflation in financial asset prices.
At least the BoE has begun the process of raising interest rates, having increased them by a total of 40 bps over the last two months with more to come. Last month the Fed passed up the opportunity to raise rates and instead signalled a March rate hike whilst continuing its asset purchase programme for another six weeks rather than bringing it to an immediate end. As for the ECB, the depo rate has not been above zero since 2012 and has been stuck in negative territory since 2014. Negative rates may be an acceptable policy option for a limited period but eight years is way too long. At least this week’s press conference provided some indication that the ECB acknowledges “inflation is likely to remain elevated for longer than previously expected [and] risks to the inflation outlook are tilted to the upside, particularly in the near term. The situation has indeed changed." Suggestions from some analysts that this marked a “hawkish” stance from the ECB is rather to miss the point. Moving rates from negative territory to zero is not “hawkish” – it reflects the start of a long-overdue normalisation of the policy stance.
Given the nature of the supply-generated inflation shock it is clear that a rise in interest rates is not going to resolve the problem. But in one sense central banks have no choice but to react. By claiming credit for the fall in inflation during the 1990s they have created a paradigm in which they appear to have control over the inflation process. Under current institutional arrangements, in which central banks maintain responsibility for controlling inflation, their whole credibility is bound up in taking action to curb it which in turn requires tightening policy. However, there may be something of the emperor’s new clothes about this argument. A hugely simplified view of using monetary policy to control inflation is the assumption that it is (to use Milton Friedman’s phrase) “always and everywhere a monetary phenomenon.” As recent events have shown, that is not the case. How do we act then upon inflation?
Dealing with the energy shock
One of the problems facing consumers around the globe is the sharp rise in energy prices. European gas production has declined in recent years and to the extent that this was used largely to smooth out demand patterns during the winter, this has had a significant impact on the market. Last summer European countries were also unable to boost storage to levels that might prevent shortages from emerging during the coldest periods and the resultant scramble for gas has pushed up global prices.
This is making its presence felt in household fuel bills. UK domestic gas and electricity prices rose by 19% and 17% respectively in October and will rise again in April following the Ofgem announcement that the energy price cap will rise by 54% which is likely to push inflation to 7% or above in Q2. Whilst the problem of rising energy costs is not a uniquely British phenomenon, it has taken a different approach to other European countries. In the UK Chancellor Rishi Sunak announced that households would receive a discount of £200 on domestic energy costs in 2022 (around 10% of an average bill) which would be repaid over the following five years. The full impact of the price hike will therefore be borne by consumers.
Elsewhere in Europe, governments have taken a more aggressive approach. With one eye on the election, the French government has forced state-owned EDF to sell nuclear power to rivals at below the current market price, costing it €8.4bn in revenue, whilst limiting the rise in household bills to 4%. The German government plans to reduce the green energy surcharge by 46% and introduce subsidies for lower income households (one person households would receive €135 and a two person household would receive €175) whilst the Irish government has planned a €113 energy rebate to every household.
Calls for wage restraint are missing the point
BoE Governor Andrew Bailey came under fire for suggesting that this week’s 25 bps rate hike was implicitly designed to deter workers from demanding big pay rises. But as many people pointed out, nothing screams wage restraint like a big rise in basic living costs. In any event workers real wages have lagged productivity growth in the decade since the GFC (chart below). Even though there has been a narrowing of the gap since 2018, workers have not been compensated for such productivity growth as has been achieved since 2009. That said, the ratio is currently in line with its long-term average. But this implies that even in a zero productivity growth economy, workers are entitled to flat real wage growth and with inflation set to average close to 6% this year, a nominal wage rise of 6% could be justified on economic grounds.
The governor’s comments were (to be polite) somewhat insensitive. It would have been far better to suggest that the BoE is raising rates to keep down inflation in order that the pay packet can stretch a little further. The FT journalist Martin Sandbu also posed the question “why does the governor of the Bank of England encourage restraint in wage demands but not call for restraint in businesses’ attempts to protect their profit margins?” With BP set to announce a huge rise in profits at a time when energy customers are struggling to find the means to pay their bills, calls for wage restraint are not a good look.
None of this is to say that central banks should not raise interest rates further. But we have to recognise that this will do little to tackle the underlying problems and that a tightening of the monetary stance maybe should be accompanied by fiscal measures to offset some of the pain, especially since rapid inflation will also boost the government’s fiscal revenues. At a time when the government is struggling to remain credible, and when many prominent Brexiteers promised that prices would go down once the UK left the EU, they need to get a grip on the inflation problem soon or voters may be tempted to take their revenge at the ballot box.
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