Article

Central bankers recognise they have a problem

This week the world’s central bankers gathered for a conference organised by the ECB. Everyone wanted to know why they got forecasts of inflation wrong.

| 7 min read

This week, the leaders of the European Central Bank (ECB), Federal Reserve Board, Bank of England and Bank of International Settlements were in conversation at the Sintra conference hosted by the ECB. There was recognition that, collectively, they had failed to forecast or prevent the rapid inflation now raging on both sides of the Atlantic. Thirteen individual European Union (EU) countries now seeing annual price rises of more than 10% and the US, the Euro-area and the UK around 8% to 9%.

The conversation was revealing. They were all speaking without a script and responding to each other’s analyses of a common problem. The ECB used the occasion to say the most, as the conference was launched by its President Christine Lagarde. She set out how she saw policy developing over the months ahead.

The ECB has been the slowest of the three to end money creation and bond-buying and to start raising interest rates. The ECB was still undertaking quantitative easing up to 1 July this year and is promising its first 0.25% rate hike at its upcoming July meeting, with a possible additional 0.25% in September.

A long European road

The ECB now argues that it is on a pathway to normal, but this will clearly be a slow journey. It wishes to undertake it gradually, though retaining the option of accelerating were the data to justify that. It is difficult to know how much worse the data would have to be to justify stronger action earlier, given that in the Eurozone inflation is now four times the target level and energy and food are bloating the price indices.

Mrs Lagarde was warming markets up to accept that inflation is likely to stay above target until 2024 with wages rising by more than 4%. She expects supply shocks to last longer and sees the EU’s lack of its own oil and gas as a major problem. She sees the net-zero transition as another source of inflationary pressures during the investment stage, though eventually solving the energy problem.

The ECB views itself as having unique problems because it acts as the central bank and currency issuer for 19 national governments that all keep some independence in their fiscal policies and have differentiated capital markets. It is particularly concerned about the markets in government bonds, where there can be substantial divergence in credit ratings and interest rates between countries in the same currency zone. Mrs Lagarde pointed out that what she calls sovereign bonds, that is Eurozone member government bonds, are the keys to the structure of interest rates for savers and borrowers in those countries. The ECB, therefore, suffers what is now called transmission problems in getting observance of a common set of interest rates throughout the region.

There will need to be creative lawyers and financiers finding a way of keeping the costs of Greek or Italian state borrowing down.

Where the US has nationwide rates led by those set by the Fed and backed up by the trade in common Federal state bonds throughout the country, the Euro area has greater ranges. This fragments markets in the zone. The ECB now wishes to have cash to buy up the bonds of countries such as Italy and Greece, to try to get their interest rates down closer to German or Austrian rates.

It intends to use money from repayments of maturing bonds in its asset portfolio, so when a German bond retires it might reinvest in Greek paper. It does not think this will give them enough firepower, so it is still working on a new instrument which would allow them to buy more of the higher-risk national bonds. It is taking time because there is a clear rule in place to prevent the monetary financing of states. There will need to be creative lawyers and financiers finding a way of keeping the costs of Greek or Italian state borrowing down without it being a version of monetary financing. Mrs Lagarde wishes it to be targeted and temporary, which she hopes will make it alright. It will be difficult to avoid a German court challenge to any imaginative project.

The Fed will be a tough guy

Jerome Powell confirmed our view that inflation is now his prime and effectively his only priority. He indicated it would be better to make the mistake of overdoing the toughness to get rid of the inflation than not doing enough to leave inflation free to roam. He agreed that a series of supply shocks of the kind we have experienced can take hold and create an inflationary psychology and continuing inflation. He will be watching inflation expectations especially carefully. Any signs of the longer-term prospects for inflation rising and he would wish to be more hawkish. Mr Powell shares President Biden’s political imperative to get inflation down. He was happy with market expectations of interest rates at 3% to 3.5% at the end of this year and 3.5% to 4% next year.

The Bank of International Settlements answered the question about poor forecasts and wrong models by accepting that it was not good at judging the supply side and was still finding it difficult to work out what will happen to damaged supply chains. It argued that the Phillips curve, which has been behind most central bank models for years, has let them down. This theory states that as unemployment falls so inflation rises. Central banks watch capacity utilisation – or more accurately levels of employment, tightening policy when labour is short and loosening when unemployment is high. This relationship failed to offer a good guide to policy needs in recent years. A period of relatively low unemployment co-existed for some time with low inflation.

None discussed the role of money and credit in a money policy and none of them answered their monetarist critics who claim to have forecast inflation from the rapid money growth the central banks undertook. They all agreed to concentrate more on longer-term inflation expectations, claiming that all the time they stay down all will be fine. Should they rise, they threaten or promise more increases in interest rates.

Knowing their thinking on inflation expectations has always been one of the key issues we monitor. The Fed is still a confirmed hawk, and the ECB is still cautious for fear of some southern states experiencing troubles with rates and government borrowing if interest rates are increased too much.

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Central bankers recognise they have a problem

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