The case for a mistake
Have central banks blundered into over-tightening?
THE DEFINING global macro narrative of the past six months has been the sharp retreat of core inflation from uncomfortably high levels in the middle of 2022—that is, from above 6% on average then to close to target today on a sequential basis. This is true of individual countries—for example, Core PCE in the United States has been closing in on 2% over the past 6 months—as well as globally—over the past 3 months, the median of core CPI globally has fallen to about 2.5% annualized.
This has happened despite unemployment remaining at very low levels—meaning, so far, no difficult trade-off in achieving the post-pandemic disinflation.
And given the famous “long and variable” lags from policy to inflation outcomes, a substantial part of recent policy tightening has yet to have its full effect.
For those engaged in the unforgiving task of reviewing the year-ahead, it may be worth speculating whether 2024 will come to be defined by a monetary policy mea culpa—where central bankers come to recognise they have over-tightened in the same way that fiscal policy was found wanting a decade ago.
Indeed, the monetary response of the last 2 years now brings the material risk of inflation undershooting target for major economies, though central bankers are yet to admit it.
Consider the following five reasons we may be living through a policy mistake.
First, the experience after the two great wars early in the last century is enlightening, where a large monetary overhang had to be worked off.
Post-WW1 saw the Fed engage in panic-tightening policy from late-1919 as inflation picked up; this was discovered to be an over-tightening that was followed by a deep deflation of wholesale prices. Policy responded by lowering the FRBNY discount rate to below the level that prevailed at the end of the war.
Post-WW2 saw interest rates held at a low level with only minimal tightening as the rise of Keynesian demand management neutralised monetary policy. This eventually led to continued inflation pressure and the Treasury-Fed Accord in 1951, liberating monetary policy once more.
The point being, a burst of inflation in light of stock imbalances can easily result in the over-tightening of monetary policy. Friedman and Schwartz summarised the post-WW1 experience thus:
The extraordinary disturbances of the World War I period certainly induced national and international adjustments in the use of real resources on a far larger scale than usual, and were unquestionably a source of uncertainty… But there can be little doubt that Federal Reserve policy was a further and not unimportant factor contributing to the severity of the movement. An earlier rise in discount rates would, at the very least, have moderated the inflationary price rise in 1919. In and of itself, such a moderation would have lessened the severity of contraction that followed. Given the mistake in 1919 it was probably another mistake to raise the discount rates a further notch in June 1920, and it was certainly a mistake to maintain those rates so long. (p. 237.)
Stocks versus flows
Second, as the above hints, a sharp distinction needs to be made between stock and flow imbalances.
The pandemic left a stock monetary overhang to be unwound alongside a flow imbalance between the supply of and demand for traded goods. The former was passed on through higher asset prices more generally, then durable and non-durable goods inflation. The last key price to adjust being wages.
But resolving a monetary overhang need not result in persistent inflation once the price level adjustment is complete.
To be left with a residual inflation problem, there would have to evolve a flow imbalance at the end of the process—a persistent tendency to credit creation or fiscal deficits. Now, there are hints at an enduring flow challenge—the fiscal deficits in the United States and the pent-up need for investment in green energy. But these are competing with a substantial disinflationary force as China’s real estate and investment boom has come to an end—the key driver of global inflation during the pre-pandemic decade.
And global credit creation has slowed sharply over the past year and is now well below the pre-pandemic norm.
From a monetary perspective, the ongoing portfolio adjustment from demand deposits into higher-yielding saving instruments has brought negative growth of money aggregates over the past year. Since this is about asset allocation rather than spending, we should not over-state the deflationary consequences of contracting money aggregates.
But the collapse in global credit creation implies the net flow of new credit is now much lower than the pre-pandemic period—suggestive of anaemic money growth ahead once the portfolio reshuffle comes to an end. This is inconsistent with global inflation mandates.
Supply chain normalisation
Third, as noted, the pandemic was associated with a flow imbalance between the supply of traded goods and demand—as transfers sustained household income while spending patterns switched towards arms-length consumption.
Of course, we have since witnessed the normalisation of supply chain pressures and commodity price inflation within core consumer prices.
Consider the November CPI print in the United States which saw commodities ex. used cars and trucks fall 0.6%MoM seasonally adjusted, comparable to the 0.7%MoM decline at the height of the pandemic in April 2020. Today’s CPI in the United Kingdom also shows very weak non-energy industrial goods price inflation.
And there may even emerge an overhang of production; together with Chinese investment in manufacturing, the risk may now be shifting towards deflation in traded goods.
The inflation targeting fumble
Fourth, one of the most remarkable developments of the past two years was the ease with which central bankers abandoned inflation forecast targeting as a strategy—that is, shifting to setting policy on the basis of incoming data instead of their projections.
While central banks consistently expected inflation to return to target, often with unchanged policy, they pushed rates higher still due to near-term forecast errors. Likewise, though inflation expectations remained more contained than spot price pressures, central banks weighed the latter more in setting policy.
The claim was that incoming inflation might be a better guide to future inflation prospects and should therefore inform policy more than forecasts or expectations. And, of course, the fact that past forecasts were so poor meant that a sense of panic seemed to take hold.
But the failure to understand, and reflect sensibly in forecasts, the post-pandemic inflation as a necessary, though time-limited, stock adjustment, allowed central bankers to become derailed from forecast targeting.
These same inflation targeting central banks now face two problems. The first is to normalise interest rates while returning to calibrating policy in a forward-looking way. The second is to see off the risk of undershooting target because they tightened too much in the first place.
The great liquidity trap escape
Fifth, related to this targeting fumble, how can we be sure we have escaped the liquidity trap—or, at least, escaped the lacklustre inflation-growth performance that characterised the pre-pandemic decade? This applies more to the Eurozone than elsewhere, of course.
The idea that policy should be slow to react to an inflation take-off to allow adequate momentum to escape the ZLB was in embedded, before the pandemic, in forward guidance and the sequencing of balance sheet action before rate increases.
Yet once inflation picked up, central banks were quick to shift gears with little consideration for whether the fundamental forces pushing towards ZLB had been resolved.
Curiously, it is possible that some of those forces have been reinforced by the pandemic, including seemingly accelerating deflationary forces in China. Within the major economies, further income and wealth inequality could be an outcome of the pandemic particularly if central banks act against catch up of nominal wages to the price level adjustment—something the BOE and ECB seems determined to enforce. This would then leave these economies with greater inequality, structurally weaker demand and inflation pressure partly as a result of the tightening cycle
Central bankers will likely spend Christmas under the illusion that their enlightened understanding and rapid policy response has coaxed the inflation genie back into the lamp.
In fact, the post-pandemic monetary response has underlined how flawed is the inflation targeting framework and just how little we understand still about the basics of how the macroeconomy works.
The monetary overhang from the pandemic required a one-off adjustment of the price level. Since central banks target future inflation and not the price level, this ought to have been largely looked-through when setting policy in a forward-looking way. Instead, policy has been found reacting to incoming inflation and therefore over-tightening.
We have been here before, as when the Fed reacted to the inflation post WW1 and reacted aggressively in 1919-20.
Now that our more recent monetary overhang has now nearly worked it was through global prices, risks for monetary policymakers are now shifting from over- to under-shooting targets.
Our mechanical reaction to inflation since the pandemic reveals much about the stale thinking of macroeconomists—expecting the same old patterns of past behaviour to repeat.
It certainly feels like there has been no improvement since Friedrich Hayek’s appeal in his Nobel Price lecture, The Pretence of Knowledge, which will celebrate its fiftieth anniversary next December.
In that lecture, Hayek criticised the ‘scientistic’ attitude which has been so greatly embedded in academic macroeconomics. Such thinking treats economics like the physical sciences whereas it deals “with essentially complex phenomena” for which the information is dispersed and often unavailable to the analyst.
For Hayek at that time, it was the uncritical, Keynesian application of a supposed “correlation between aggregate demand and total employment… accepted as the only causal connection that counts” that was pushing inflation ever higher while disorganising the basis of production.
The past few years have instead witnessed the unthinking application of the apparent Phillips Curve link between inflation and unemployment. And it has led to central banks, unaware they were dealing mainly with a stock adjustment, to abandon forecast targeting and to tighten policy despite no evidence that inflation has become structurally embedded.
And so, 2024 might be defined by the re-emergence of deflation risk—in which case, perhaps we can look forward to yet another mea culpa from mainstream of macro-policymakers.
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