I have long argued that central bankers, especially those elevated to superstardom by supporters, have appropriated far more than their share of credit for the long period of macroeconomic stability since the early eighties.
Two factors to be borne in mind. One, central banks were aided by several critical inflation lowering tailwinds in the world economy - globalisation and integration of markets, expansion of trade on the back of container shipping etc, supply chain unbundling due to the ICT revolution and lower transportation costs, the emergence of China as a low-cost supplier, savings glut in developing countries due to demographic trends etc. Two, it's generally far easier to keep the ship running when waters are calm than to navigate when things turn choppy.
Driving home this point, in a recent FT article Richard Bernstein compared the Fed Chairman to a Maytag Repairman,
The Maytag Repairman was a fictional washing machine mechanic who was lonely because no one ever needed to repair a reliable Maytag appliance. Instead of tools, he carried a book of crossword puzzles and cards to play solitaire to combat his boredom. For many years, the US Federal Reserve played the role of the Maytag Repairman with respect to inflation. With the expansion of globalisation and the resulting secular disinflation, there wasn’t much for it to do to fight inflation. Rather, it could generously ease monetary policy during periods of financial market volatility without much concern that its efforts to save investors might spur inflation.
Andy Haldane, one of the most balanced commentators on central banking, has this to say about the challenges faced by central banks in recent time
The evidence of the past two years suggests two lessons for policymakers from two mini-monetary mistakes. The first is that central banks were initially too slow off the mark in tightening policy, misdiagnosing a large, lasting and broadly-based rise in prices as a modest, temporary and energy-specific one. The second is that central banks then engaged in a game of catch-up, both with inflation and their own credibility. This came just as demand was stalling, making a bad growth situation worse. It has cast doubt on the wisdom and sustainability of monetary tightening. This leaves many central banks struggling to communicate their intentions. Should monetary policy stick (to curb further harm to the economy) or twist (to curb future inflationary pressures)? This uncertainty has caused financial markets to whipsaw, and inflation expectations to wobble...
This shift upward in the equilibrium global price level is the mirror image of the golden age of globalisation that occurred after the second world war, when global supply chains lengthened and deepened, contributing to inflation persistently undershooting its target in many countries, including Japan, the US and eurozone. That golden era is now over, because supply chains take time to repair and reconfigure, particularly for people and their skills. The resulting reflation seems set to persist for a period measured in years not quarters. Large and lasting global supply shocks of this type put monetary policymakers on the horns of a dilemma. Do they tolerate above-target inflation — in line with the initial (in)action of central banks recently? Or do they continue to raise rates to counter high and sticky prices — in line with their subsequent (hyper)activity?
This is a teachable summary. Central banks globally have been steered by reputed academic experts for several years during which interest rates were kept low. Some observations
1. The questions raised by Haldane are complex ones, which have no theoretical answers. Instead, their answers, especially when central bankers are responding in real-time, has to be based on good judgement. Such good judgement requires conceptual understanding of the drivers of inflation, information about prevailing global economic trends including that gathered from conversations with market participants, experience of having engaged on situations before, and an ability to analyse the situation by combining inputs from all the first three.
2. This requires a pragmatic approach, which while being proficient on the models and theories does not become captured by them, and instead analyses information in an objective and non-ideological manner, and exercises good judgement to decide on the monetary policy choice. Such ability is most often beyond the mental models of academic economists who are strongly encumbered by theoretical frameworks and are resistant to choices which require junking those models. Besides they have limited or no real-world experience, and the associated data points, in being able to exercise good judgement.
3. As with all judgement calls, the likelihood of getting wrong is ever-present. In such cases, just as failure does not confirm incompetence, success does not confirm competence.
4. Such decisions are deeply inter-connected. For one, the US Federal Reserve has become the de-facto benchmark on monetary policy across the world. The Fed acts, and the others must follow. Then there is the innate herd-mentality of the market and investors, which shapes monetary policy actions in certain directions. This is a human failing and global financial integration ensures that such trends have become unavoidable.
Haldane by the way believes that higher inflation levels have become globalised and here to stay for a few years, and therefore the correct monetary policy response may be less in raising target inflation levels but in extending the time horizons over which inflation levels can be returned to the target. As discussed above, whether this horizon expansion is likely to be effective or not (in controlling inflation) is less theory and more a matter of good judgement.
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