We use cookies to help improve and maintain our site. More information.

19 May 2023

Taking back control - inflation edition

The politics of inflation bears some uncanny resemblances to the politics of Brexit. Brexit divided the UK into a southern, Metropolitan and a northern industrial camp. Inflation opens up similar divides. The poor are, of course, more affected by inflation than the rich. What is new is that the rise in inflation risks political misjudgements of a kind similar to those that led to Brexit.

I know of a lot of economists, especially on the left, who have a relatively low regard for the goal price stability, and who would like central banks to focus on growth and employment. They regard the fixation with price stability as bourgeois. Their mindset dates back to the 20th century when Keynesian economic policies were associated with policies that favour the working classes. Back then, the main economic policy trade-off was between inflation and unemployment. Workers suffered from unemployment, but much less from the inflation. In the 1970s, trade unions managed to negotiate above-inflation wage deals. Wealthy people, by contrast, were more affected by inflation than unemployment. Back in those days, the right hated inflation, and the left hated the policies to fight it.

Today, the picture is totally reversed. The poor and low-income earners have the greatest interest in stable prices because the decline of trade union power meant they have no one to look after their interests - except for the central bank.

Middle and higher income earners, by contrast, these days have more ways to protect themselves against inflation than they used to. They no longer hold their wealth in cash or bank deposits, but in property or stocks. Their biggest risk is the high interest rates needed to bring inflation down.

In between those periods, there was a brief interlude - from around 1990 until 2020 - during which a consensus emerged that low inflation would benefit everybody. The argument went as follows: since we all agree on the goal, we might as well leave the details to the experts. It was the golden age of macroeconomics and central bank independence.

That age is coming to an end because central banks have failed to deliver on the deal. They are still independent, but what is changing is the broad consensus on which their independence rests. Monetary policy has become political again. It started with the global financial crisis when central banks adopted quantitative easing, the purchase of government bonds. During the pandemic, they bankrolled fiscal stimulus. It was the age during which central banks discovered the art of the possible. In the process they made owners of financial assets richer.

Now they stand accused of making the poor poorer by allowing inflation to rise. They are not to blame for the supply chain shortages during the pandemic, and Vladimir Putin’s war. Price shocks happen. Their mistake was underestimating the knock-on effects and failing to act.

They rose interest rates eventually, belatedly and reluctantly, and keep on feeding expectations that the worst is soon over. Interest rates are still below the levels of underlying inflation in the eurozone and the UK. This would suggest that the central banks are betting on inflation coming down by itself. Their fast and furious reaction to the global financial crisis stands in marked contrast to their comparative complacency about inflation today.

Most at risk in my view is the UK, a medium-sized country with a large financial sector. Andrew Bailey, the governor of the Bank of England, sometimes gives the impression that he prioritises financial stability while only paying lip service to inflation targets. Even in the best of times, central banks face trade-offs between low inflation and financial stability. This phenomenon is known as financial dominance. It is what stops them today from raising interest rates to 6%, or whatever it takes to get inflation back to 2%. Raising rates that high would risk a housing market crash, and trigger a financial squeeze. Maybe worse. It would turn into a middle-class nightmare.

Contrast this with the late 1970s. When Margaret Thatcher came to power in 1979, her government raised interest rates to 17% by November of that year. It was middle-class England that voted her into power. Today, it is the middle class, and their representatives, and the media that are demanding that the Bank of England treads cautiously.

Some economists even want the central banks to raise the inflation target. They argue that the pain to get inflation all the way down to 2% is just too much. In other words, they want to move the goal to where the ball is going. And they are trying to dress this up a technical necessity - as opposed to what it really is: a political choice.

The re-politicisation of monetary policy brings us back to Brexit. EU membership, the single market, and financial integration in Europe benefited some people more than others. The Metropolitan political bubble failed to see this. A version of this is happening again, this time in another area. The policy advocacy of the left no longer works for the constituency of the left.

We should therefore not be surprised if new political parties or groupings inside parties were to emerge with an agenda to take back control - from the central banks. We have seen a tentative first step in that direction in Australia where the government decided to clip the wings of the central bank governor for failing to address inflation on time. The Australian central bank is still independent, but this episode should serve as a warning shot to central bankers elsewhere in the world that their status is not assured. It may happen at a central bank near you.

If you would like us to notify you when a new column appears, please fill out this form.