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Central banks damned if they do, and...

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28 February 2011 14:31

The sharp rise in world commodity prices has put some central banks overseas in a bind. These higher prices will inevitably feed into headline inflation. For central banks with an inflation target, or even for those which for decades have emphasised that their over-riding target is price stability, this seems to be a clear trigger to raise interest rates. But at the same time unemployment in many of these countries (UK, US and many parts of Europe) suggests it would be damaging and unnecessary to restrain economies which are already operating well below capacity.

This bind is to some degree self-inflicted. Central bankers have often found it convenient to talk as if price stability is their only goal. Inflation targeting reinforces this single-goal mind-set.

Such single-mindedness serves a good purpose: it tells the public that the central bank has staked its reputation on keeping inflation low. This in turn keeps inflation expectations low. Expectations are the key driver of persistent inflation. When the central bank makes a credible threat to 'take away the punch bowl just when the party is getting to be fun', producers will be reluctant to raise prices and consumers will be more ready to resist any attempt to do so.

But simple rules, as usual, are inadequate for the complexity and ambiguity of the real world. The simple single objective is a convenient fiction. Price expectations are not the only factor driving inflation.

If the economy is running too fast, inflation will increase. All central bankers understand it is their job to take away the punch bowl in these circumstances. There is no ambiguity here. But what if inflation has been pushed up by price rises of imported commodities'

This may reflect excess demand, but it is demand/supply imbalance in the whole world that is pushing up these prices. Tightening domestic policy won't affect international prices. Higher interest rates may strengthen the exchange rate, which makes imports a bit cheaper. It might also depress prices of domestically-produced goods, so that the average price level is restrained. But both these channels put downward pressure on domestic activity, which will be unhelpful if activity is already weak.

This is the sort of bind the Bank of England finds itself in. Inflation is running at 4% and is expected to rise, perhaps to as high as 5%, over the next year. A prospective increase in VAT adds to the damage done by imported commodity prices.

Both common sense and economic analysis suggest that the Bank of England should 'look through' these short-term influences. With limp domestic activity and unemployment almost 8%, inflation should come back down again when these once-off influences pass through the system.

That said, there is some danger that the higher inflation will push up price expectations and thus this higher inflation will persist. Inflation has been over the Bank of England's 2% target since December 2009, averaging 3% over the past three years. Thus inaction presents some risk to the Bank's anti-inflation reputation.

Cool-headed analysis of these conflicting factors is not helped by the cat-calls from old-fashioned monetarists who still carry the baggage that inflation is always and everywhere the product of spineless and morally degenerate central banks. A further element of this monetarist baggage is the assertion that monetary policy has no effect on output. In this rarefied monetarist world, tighter policy trims inflation without any cost to output. It's just possible that this may be true in the long run, but is certainly not true in the short run, say over the next few years.

Thus far Bank of England Governor Mervyn King is resisting the 'inflation nutters' and even those on his monetary committee who are uncomfortable with the abnormally low official rate. His quandary is increased by the bold (Sir Humphrey would call it 'courageous') effort of the UK Government to rein in the budget deficit quickly, with a view to getting the UK’s debt levels under control. This austerity will dampen activity for the foreseeable future.

Perhaps it would be helpful to superimpose St Augustine's Strategy ('make me good, Lord, but not yet') on conventional monetary policy: leave rates as they are but emphasise that at some stage they must get back to more normal levels.

The UK represents the quandary at its worst, but it is not alone. Europe's inflation is running at 2.5%, lower than the UK but still clearly above the ECB's strongly-preferred 2%. Even German inflation is close to 2% and increasing. Europe has the additional problem of stark differences in activity levels among EU members. Germany's unemployment is low, but Spain's is at nearly 20%. And a bit of inflation in Germany might just give the peripheral Euro countries wiggle-room to sort out the messes they are in.

Neither the US nor Japan is an inflation targeter, so it may be easier for them to resist the pressures to respond to supply-side cost-push inflation. But the prominence all central banks have given to their price stability objective means central banks in these two countries, too, will come under pressure to tighten despite weak activity.

In the emerging countries, central banks face a different problem. In China, India, Indonesia and Brazil, activity is strong, and inflation is rising. They should tighten their monetary stance. For them, the quandary is different. If they raise interest rates, foreign investors searching for yield will add to the already large capital inflows. Exchange rates will be pushed up even higher than the current painfully strong levels.

The Global Financial Crisis still casts a long shadow.

Photo by Flickr user Meredith_Farmer.

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