Strong Words, Mate

How credible is the message from central banks that they can and will bring down inflation?

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SMASHIE: What ever did happen to The Wombles, mate?

NICEY: Good point, one certainly worth making. What happened to the Wombles. Well I'll tell you. There they were, underground over-ground a-wombling free, and then, no more, they were, were they, not here... where they were... type stuff...

SMASHIE: Wombling wise words, mate.

On Friday I wrote about what the heads of the Fed, the ECB, the BOE and the BIS didn't say during their appearance together on stage at the ECB's annual forum on central banking last week. Namely, that a large component of the high inflation in the US and, because of interconnectedness, globally was due to president Biden's excessive $1.9tr American Recovery Plan enacted in March last year.

I thought that today I would write about what they did say, having listened to all 85 minutes of the panel discussion.

It is important to note that it is not the job of central banks to get their economic predictions correct but to maintain price stability and full employment. They are not passive observers outside the system but very much inside it, part of it. What they say should not be considered an objective assessment of the outlook for growth and inflation but something that can influence them, significantly. Indeed the ability to influence markets is a key weapon in central banks' armoury, and it appears they were putting it to good use last week.

What came across most strongly was the determination of the three country heads to get inflation down to target i.e., 2%, though they would not be drawn on what this might take in the way of interest rate increases. It was paramount, they said, that high inflation must not become entrenched, that the vicious cycle of rising prices must be stopped. The implication of this of course is that they are saying that high inflation is not yet entrenched. Is this credible? Just, perhaps.

The GM of the BIS, Agustín Carstens, noted, when asked about high inflation in the 70s, that central banks today were much stronger than back then. In the 70s, he said, the collapse of Bretton Woods put huge strains on central banks and the effectiveness of their monetary policy. He made no mention of currently bloated balance sheets and how these might impact central banks' ability to bring down inflation.

The head of the Fed Jerome Powell made it clear that he was not focussed on financial markets but on policy that would get inflation down to 2% while keeping the labour market strong, namely: to slow growth with higher interest rates in order to bring down demand and thus to allow demand and supply to get back into balance. He made it sound so simple, so... easy.

He noted the "multiplicity of shocks" and how these had caused the start of a transition into a higher inflation regime. "Our job is to prevent that from happening, and we will prevent that from happening...We will not allow a transition from a low inflation environment to a high inflation environment."

As for longer-term inflation expectations, he said that they were still well anchored but that they could not assume they would stay that way. "The cost of a higher inflation regime is so great that you cannot allow that to happen."

Strong words. But in some respects they are empty ones. If Powell does not succeed in getting inflation down he will be out of a job. And are longer-term inflation expectations really still well anchored? Anchored possibly but well anchored? Words matter, but then of course the mere hint that long-term expectations were not well anchored would have sent them rushing to the surface.

As for US fiscal policy aka the $1.9tr American Recovery Plan the moderator asked whether the impact it would have on inflation had been miscalculated. It was clear that none of the three country heads would lay the blame at the feet of president Biden so the question was fielded by Carstens. He said that, "The traditional components of toolbox that we had to analyse inflation had turned out to be not so reliable...the Phillips Curve that has been a workhorse...BIS research suggested inflation could not rise very much, but it was very wrong...non-linearity...inflation today very different to that in the 70s."

Is the inflation today very different to that in the 70s? Things are always different but in this case I'm not sure they are very different. As I noted a couple of weeks ago, the inflation of the 70s was rooted in excessive fiscal spending in the US in from 1965 onwards. And, get this, the Phillips Curve back then had also told them that inflation could not rise! Once is careless...twice is...

It could in fact be argued that the inflation today could be worse than it was in the 70s. Why? Because today central banks' balance sheets are as bloated as they have ever been. Gone are open market operations that could be used back then to influence interest rates. Today, central banks must pay interest on banks' gargantuan reserves held with them. How long can this go on for, one wonders?

ECB head Christine Lagarde did admit that, "as economists we need to do better in understanding aggregate supply. We were trained under the dominance of aggregate demand, taking aggregate supply as given. It's very complex." She also noted that in the EU, "unique monetary poilicy has to be transmitted throughout this Imperfect market of fiscal union, no monetary union, no capital markets union."

Powell also said that, "I think we understand better about how little we understand about inflation. A year ago, 34 of 35 economists who provided inflation predictions to Fed had inflation in 2021 below 2020. Everyone had the same model which was the Phillips Curve model but what it was missing was something that has been missing from the data for 40 years namely a collapse of the supply side. Very strong demand hitting a vertical supply curve meant a big price increase. What we got wrong was looking at supply side issues and thinking they would be resolved relatively quickly, that people would be vacinated quickly [and get back to work]. That didn't happen, and then we had the new shock of the war."

He went on to say that, "There is threat of chains becoming shorter and more secure rather than longer and insecure, but this makes them inefficient."

Bank of England head Andrew Bailey said that he was focussed on "second round effects" i.e. wage increases and that this was a "crucial point of monetary policy". He also wondered why investment had not been stronger in recent years. "A gap has openned up between the risk free rate and return and yet investment has been subdued. Are we capturing investment? Is there investment of the non traditional sort [that we are not capturing]?"

Carstens noted that the roles of fiscal and monetary policy to [provide stability] into the future are hitting limits. We don't have the resilience in growth that we would like to see."

The moderator asked, "Has there been an over reliance on monetary policy?"

Powell's response was, "Yes. There has not been enough focus on supply side. That is not the Fed's job. More the job of elected governments." He said that when asked by elected officials about his thoughts on government policy, he tells them to focus on investing in people, to increase the productive capacity of the economy over the long term. He was clear that the Fed must stick to what it's supposed to do and leave the rest to elected officials. This was as close as anyone got to blaming the acceleration in prices on Biden's $1.9tr American Recovery Plan.

Lagarde noted that the ECB must, "stick to its knitting but when asked for advice [by governments] should give it. Fiscal and monetary have worked well together during the pandemic. But what we have now is not what we had during the pandemic. The advice is: invest in people, investing in green."

Bailey made the point that, "[central bank] independence goes both ways and we must respect that and we do...why has the trend rate of growth fallen, and in our case it has the central bank I am not going to prescribe what should be done about it...that is outside our remit...but we have a big interest in trend growth...something we watch carefully so something we can collaborate on."

Three more comments of interest:

Powell: "The process of gettiing inflation down will involve some pain but not getting it down would be more painful"

Bailey: "this sort of inflation is even more painful for low income groups because it is concentrated in the essentials - energy and food".

Lagarde: “There are forces that have been unleashed as a result of the pandemic [and] as a result of this massive geopolitical shock [Ukraine] that are going to change the picture and the landscape within which we operate.”

I found many of these comments insightful and may well write more about them. For the time being I will just let them sit...well anchored.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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