Could better monetary policy have kept a lid on the global inflation shock? Probably not, on the whole — but central banks now need to tread very carefully if they’re to avoid crashing their economies.
(Bloomberg) — Could better monetary policy have kept a lid on the global inflation shock? Probably not, on the whole — but central banks now need to tread very carefully if they’re to avoid crashing their economies.
Those are the views of Lucrezia Reichlin, a professor of economics at London Business School and a former director general of research at the European Central Bank. A key takeaway from the whole episode, she argues, is that governments and central banks need to work more closely together so their policies complement each other.
The backdrop is the steepest price increases for generations, in the aftermath of the pandemic and Russia’s invasion of Ukraine. Headline inflation is now receding in most advanced economies (the UK being an outlier) — but not fast enough for central bankers, who’ve already hiked interest rates by the most in forty years, and have been warning lately that borrowing costs need to go higher still.
The following are extracts from the conversation with Reichlin, who helped to pioneer “now-casting” — a technique for estimating economic conditions in real time, instead of waiting for lagged data to come in. They’ve been lightly edited for clarity.
Are central banks to blame for not moving fast enough?
Maybe they were a few months delayed, but if that delay had been so costly this would have been reflected in inflation expectations. On the contrary, medium-term inflation expectations are anchored at the central banks’ target. I don’t think they have lost credibility.
When people talk about central banks being late and so on, they don’t appreciate the sequence of the extraordinary shocks and the size of the shocks. Because of the nature of the shock, essentially a large relative price change, we have seen a persistent dynamic of inflation. This is because there are delays in which the price of inputs are absorbed and get reflected in the prices of outputs.
For example, as energy prices go up, manufacturing absorbs the increase first — because it is a direct user of energy — and services later, because they use energy indirectly. Given the rigidity of prices and the different lags with which different sectors absorb energy price changes, inflation becomes persistent. This is exactly what we are seeing. Headline inflation has gone down as shocks recede but core inflation is quite persistent. Central banks can do very little to address this problem.
What is the balance of risks in pushing up interest rates even as economies slow?
Central banks are likely to make a mistake in tightening too much. Some central bankers have said, “It’s better to do too much than too little.” Are we sure? Consumption and investment in Europe are well below pre-2019 trend. There is a real material risk that they will do too much, which will have an effect on the real economy.
Our economies have gone through a financial crisis and then Covid, the last thing we need is another serious slowdown. The effect of this massive tightening is not visible yet. The future quarters are going to be challenging, and I’m worried they will keep interest rates too high for too long.
How can we be confident that inflation will continue to slow?
The situation is less abnormal than is made out in a lot of commentary, and I’m persuaded that we will gradually normalize. I don’t think we should worry too much about labor markets because wages have been quite subdued, especially in Europe, and I don’t think we should be too worried about inflation expectations because they are well anchored.
But we should worry about fiscal policy being unable to absorb the fiscal deficit produced during Covid. Aggressive monetary-policy tightening and loose fiscal policy is not a good combination. This is a case in which we should have a very careful coordination of fiscal and monetary policy, and if that cooperation is not achieved then there could be more persistent inflation than my core scenario.
How will that impact central bank independence?
There have been a lot of changes in what central banks do — big balance sheets, big financial market intervention, and now inflation. So the challenge to independence is definitely there. But I don’t think it should be overstated. Governments are not in good shape. Everybody understands that an independent central bank is a public good, especially in the context of divided government. The monetary and fiscal policy coordination that I have advocated does not require a central bank that is subordinate to the government.
How long does it take for core inflation to slow after an energy shock?
Core inflation after an energy shock goes up with a delay, and goes back to the initial level only after 60 months. So we are more or less in the norm. Except for the UK, we have seen headline inflation go down rapidly.
What’s your main message to central banks?
There is room for being patient. I think we have tightened enough.
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