With friends like these, who needs enemies

By: Eurointelligence ECB Watch

When inflation rises, central banks get loads of bad advice. It usually consists of some trumped up arguments, sometimes dressed up as a new academic insight, purporting to show that it is wrong to raise interest rates at this time.

 

We have identified four categories of bad advice. There are probably more, but these are among the most important. The first, which we have passed sometime ago, concerns the inflation measure itself. It says: Don’t use headline inflation; use core inflation instead, or some other measure that takes the inflation out of the inflation. Another one is: Ignore imported inflation, and only care about domestically generated inflation. There is now lively debate about the concept of pure inflation, a intellectual intriguing idea with the one minor shortcoming that it cannot be properly measured.

 

The second type of bad advice is a tad more aggressive. It says the central bank should adjust its goals. The European Central Bank’s main policy goals are price stability and financial stability. The Federal Reserve’s also include growth and employment.

 

In reality, however, the policy conflict for central banks is not nearly as dramatic as some commentators would make you believe. While a central bank should not raise interest rates on the day of a bank run, there is no reason why the tolerance of higher inflation would help stabilise the financial system. Just imagine if US annual inflation remained at the most recent level of 5 per cent. The US bond market would tank, and global investors would pull their money out.

 

The other goal conflict is between growth and inflation. The old version of this debate is not entirely relevant today. We no longer believe that we can generate higher growth through inflation. Instead, there is now a consensus that the consistent pursuit of an inflation target constitutes a good countercyclical policy.

 

But there is modern version of the growth versus inflation trade-off that is a lot more subtle. It is an insurance-seeking argument – the third of our four types of bad advice. The argument is based on the idea that a central bank should cut interest rates below the level needed to stabilise inflation, to prevent some disastrous turn of events in the future, such as a depression. The argument is that if a central bank is credible, it will always be able to reclaim its credibility later. In this case, the central bank says: Don’t judge us on our interest rate cuts now. Judge us on our ability to reverse our course later.

 

The insurance argument is a bad basis to conduct monetary policy because you can insure yourself against anything in all directions, and you end up once more in a purely discretionary world. Just as you can insure against deflation, you can insure your against hyper-inflation. For example, some European central bankers justified the most recent interest rate increase as a warning to wage negotiators: in other words, as an insurance against second-round inflationary effects.

This type of reasoning is an old European insurance reflex. It could, and should, have been justified on much more rational grounds: The ECB’s own staff is forecasting inflation to overshoot the target over a medium term target. On that basis, the ECB could even justify another rate increase as well.

 

The forth and final category of bad advice consists of recommendations to raise the inflation target at a time when you miss it. Last week, two senior members of the European Parliament’s economic and monetary affairs committee issued a draft recommendation that the ECB should shift its inflation target to take account of international developments; that it should adopt a target band, instead of a target; and that it should produce its own inflation forecast. While we like the last proposal, we nevertheless find it counterproductive to raise an inflation target at a time when inflation has hit 4 per cent. Monetary policy is about management of expectations. A shift in the goal post when you are missing the goal destroys a central bank’s credibility.

 

For the same reason, we never thought much of the UK’s framework, where the government has the right to set the target. It is fake democracy. It conveys a right on the government to use an instrument that it can never use when it needs to, though it can use it at all other times. The whole idea of any target is that you adjust policy to meet the target, and not the other way round. People will otherwise lose confidence in the process, and adjust their inflation expectations.

 

 

Beyond the short-term, there are a number of issues thrown up by our most recent experience. But none of these have any relevance on current monetary policy. We should think about whether and to what extent globalisation influence monetary policy. The outcome of such a discussion might well mean a shift in the inflation target in either direction at some stage. It might also mean greater international co-operation between monetary authorities. We might also want a debate about how central banks and governments should deal with asset price bubbles. So far, we have not yet found a satisfactory answer to that question.

 

In the meantime, central banks should not drop the ball, and do their job to stabilise inflation. 

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