Time To Step Up
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Until recently, central bankers had been seen as heroes for the best part of four decades
For investors not yet convinced that high inflation is necessarily a bad thing, let me remind them that from 1965 to 1981, it caused equity/bond balanced funds to plummet in real terms - in the case of US funds by a whopping 41pct. Also, while the term cost of living crisis was not in circulation back then, this is precisely what the 1970s were for millions.
Furthermore, the cure, when it came, was costly. The high interest rates required to bring inflation down caused a recessionary environment for most of 1980, 1981 and 1982. There is thus very good reason why the primary objective of central banks is to maintain price stability.
Inflation is an overall increase in the value of goods and services in money terms i.e., prices. It is therefore a decrease in the value of money in terms of goods and services. In other words, it represents a loss of that most precious of things we take for granted: a stable currency.
Maintaining price stability is thus so much more important than it sounds. If the value of money is not regarded as sacrosanct, you end up like Zimbabwe, Venezuela, Turkey, or Weimar Germany.
This is why the important job of maintaining price stability is put in the hands of independent central banks rather than in those of politicians whose need to garner votes constitutes a clear conflict of interest.
Now is the time for central bankers to earn their stripes. Until recently, they had been considered heroes for the best part of four decades. Although he was despised by many at the time for inducing a long and nasty recession in the early 1980s with his high interest rates, Paul Volker is now remembered as a saviour.
His successor, Alan Greenspan, was nicknamed The Maestro - during his tenure inflation was as low and stable as it had ever been in the modern era. Then came Ben Bernanke who rescued the world from depression with his well articulated QE framework, while across the pond Mario "whatever it takes" Draghi came to the aid of a teetering Euro.
After Bernanke came Janet Yellen, though her reign from 2014-2018 was unremarkable, other than for not being renominated by president Trump for a second term because she was too short. Instead, Trump nominated the 6' tall Jerome Powell, who performed admirably in the early and worrying months of the pandemic, presumably because he was able to peer down on the virus and see how dangerous it was.
Unfortunately, Powell's stock price and those of his peers at the Bank of England and the ECB have in recent months been in decline. This is understandable: they have been failing in their main task of maintaining price stability. In some respects this failure is through no fault of their own: the pandemic presented a unique challenge because of its impact on both supply and demand. And, of course, because of the particularly terrible impact it had on peoples' lives.
In other respects, however, I believe central banks have been culpable. As I wrote on Tuesday, while to an extent they can be forgiven for getting their central forecasts wrong, they were remiss in not addressing the possibility that inflation could be higher than they expected. The Fed was happy to propose an alternative scenario in which inflation would be lower than expected. Surely it could and should have taken the opportunity to put forward a second alternative scenario, one in which inflation would be higher than their central forecasts.
Indeed, given the massive monetary and fiscal stimulus that prevailed alongside the ongoing supply side issues in late 2020 and throughout 2021, plus the fact that labour markets were recovering quickly, this would have been a more reasonable alternative scenario. It almost seemed as if central banks got caught up in the emotion of the times, rather than staying above the fray as they normally do.
As a result of their mistakes, central banks' have been pilloried and had their independence threatened. This is worrying, and some former central bankers have been coming to their aid.
In June, GM of the BIS and former governor of the Mexican central bank, Agustín Carstens, joined the heads of the US, European and UK central banks on a panel discussion at the ECB's annual forum on central banking. To be fair, the latter three seemed prepared to admit to having seen covid as just a supply crisis, though it was Carstens who fielded the questions as to whether excessive fiscal stimulus had been to blame.
More recently, Raghuram Rajan, who held posts both as chief economist at the IMF and as governor of India's central bank, felt the need to stick up for them. He recently wrote an op-ed in The FT entitled Stop berating central banks and let them tackle inflation. A number of his points were good ones but some sounded lame.
For example, early in the piece he trots out that age old saying that hindsight is 20/20 and that the consequences for economies of what was an unprecedented crisis were "very hard to predict". This is true, but my point is not that central banks got their central forecasts wrong but that higher than expected inflation, in light of tight supply and excessive fiscal and monetary stimulus, should at least have been considered a possibility. It would certainly have helped paint central banks in a more favourable light today if they could point to having put forward such a scenario.
He then invokes Russia's unpredictable invasion of Ukraine as having been a major contributor to higher inflation. In the US, inflation before the invasion was 7.9pct. It is now 8.5pct. In other words, most of the rise occurred beforehand.
Rajan also writes that The Fed's decision during the pandemic to tolerate higher inflation was a mistake but then asks, "But who knew the times were a-changing?" Surely the pandemic alone was reason to think that the world was facing new challenges. However, trade protectionism, an undoubtedly inflationary force, had also been on the rise prior to the pandemic. Might this not also have been considered a possible reversal of the inflation-friendly trend towards globalisation that had been in place for several decades?
Next, Rajan writes that a central bank's policies have to "be seen as reasonable, or else it loses its independence". Surely, just as big a threat to independence is the failure to consider worst case scenarios, in this case the possibility of higher than expected inflation, something that given the prevailing excessive fiscal stimulus and supply constraints would have been reasonable.
Rajan saves his best till last. He writes that once central banks succeed in bringing inflation down, we will probably return to a low-inflation, low-growth world, one that is subject to the headwinds of, among other things, de-globalisation. Huh? De-globalisation is inflationary, not deflationary!
I am not being critical of central banks for the sake of it. It worries me greatly that their ability to do their job of maintaining price stability, for reasons both outside and within their control, is being hindered.
It was encouraging that Powell's recent speech at this year's Jackson Hole gathering had more of a "whatever it takes" tone with respect to bringing down inflation. However, what is still missing is some brutal honesty with respect to the pain that will almost certainly need to be induced in the process.
The longer inflation stays high, the more real wages get eroded, and the greater the risk of a wage spiral, what Bank of England governor Andrew Bailey has referred to as second round effects. Once an inflation mindset gets settled in, it is very hard to evict.
Of course, it is possible that central banks will not have to deliver the harsh message relating to pain ahead. Financial markets, as they often if not always have done on previous occasions, may do that for them. Moreover, it might be better if that happened sooner rather than later.
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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