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26 September 2021

Five Stages of inflation denial

This is not a column about whether inflation will rise or not. There are reasons to think that it might, but reasonable people can disagree on that point. This column is about how to spot cognitive biases in central bankers in their ability to spot inflation.

As in the famous five stages of grief, there are also five stages of inflation denial. We have not reached stage five yet, and may never do. But stages one and two are well occupied, including by members of the European Central Bank’s governing council and countless economists.

The first stage is asymmetry. The ECB has recently adopted a symmetric inflation target, but the human mind struggles with symmetry. Isabel Schnabel, a member of the ECB’s executive board, for example said recently that it would be worse to tighten too early than tighten too late. We know of course that the ECB is still traumatised by the premature tightening that took place in 2008 and 2011. Many central banks, including the ECB, have an inflation target of 2%. Symmetry means that 3% is as bad as 1%, and 4% is as bad as 0%. It means that getting it wrong in one direction is as bad as getting it wrong in the other direction. You should be indifferent between premature tightening and acting too late.

If you say you prefer the former to the latter, you are asymmetric. All you have done is replace the downward bias of the previous period with upward bias now. Symmetry is not the sum of two asymmetries.

The second of the five stages is a shift in the definition of inflation. The ECB’s target is the harmonised index of consumer prices. But the central bank now formally added core inflation into its analytical framework, which I think is perfectly justified. But be careful about going further. In the US, we have heard economists talk about core-core-inflation. If you take all the goods with rising prices out of the index, like second-hand cars, you end up with price stability as a statistical mirage.

The third stage is a shift in your strategy, often concealed by technical language. The Federal Reserve’s average inflation target falls into that category. The ECB has mercifully dodged that bullet in its recent strategy review, but I fear that some members of the governing council still intent on pursuing it. Average inflation targeting, if applied over a sufficiently long period, is the same as price level targeting where the central bank tracks an index. In doing so, it corrects for all past mistakes. There are good reasons why central banks should not do this. The most important is the rearview mirror problem. Your policy is by definition backward-oriented.

The fourth stage of inflation denial comes when stages one to three have failed and inflation has gone up, on any metric, no matter how you look at it. At that point, you pretend that the inflation is temporary and self-correcting. Last week there were countless references from ECB members about the hump-shaped inflation curve. But beware: every inflationary period in the past started with an event that was initially believed to be a blip, like the oil price shock in the 1970s. To understand inflation is to understand how the economy adjusts to shocks. Unfortunately, central banks rely on economic models that themselves have no notion of how shocks promulgate.

The final stage of inflation denial occurs when inflation has gone up and proven persistent. At that point, the inflation deniers are suddenly changing their story: better 10% inflation than 10% unemployment. This is, of course, what they thought along but did not admit.

There are central bankers for whom inflation can never be low enough. And there are those who believe that inflation must never fall below a minimum threshold. They are the hawks and the doves. Neither of them is symmetric. Symmetry is really hard. And rare among central bankers.

I keep an open mind on whether inflation will go up or not. What worries me is not so much whether inflation will rise but what central banks will do, or not do, if it does.

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