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We are behind the inflation curve

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Ludek Niedermayer is an economist and a former vice-governor of the Czech National Bank. He has been a member of the European People’s Party in the European Parliament since 2014. 

For over a decade, central banks were more preoccupied with the risk of deflation than inflation, their boards spending most of their time and effort trying to increase inflation by a few tenths to reach their 2 percent target — considered a good level of price stability at the time. 

But almost overnight, they are now struggling to keep inflation within single digits. 

It would be unfair to blame central bankers for not being able to anticipate what happened, as it was a set of unique factors that caused this change, and judging whether an inflation spike is temporary or if there’s a serious risk of long-term inflation was difficult, if not impossible — at least until the autumn of last year. 

Now, however, to say that by not acting early enough, many of them made a mistake that undermined their credibility seems to be a fair judgement. Central banks have fallen behind the curve. And as a former central banker myself, I believe there are several systemic factors that put them on the wrong track. 

The first factor to consider is excessive transparency. Central banks are always very transparent, and they are clear about their targets, disclosing how they make decisions and which tools they use. During the deflation, however, some pushed transparency even further with commitments to future policy actions. And though breach of these “promises” could not be sanctioned, central bankers took them very seriously. 

Such firm commitments are no longer used, but it does seem that the often communicated “plan of further action” played a significant role in central banks’ (in)ability to act quickly. 

In early 2022, both central banks and most economists expected 2023 would be a year of very slow recovery from the COVID-19 economy. And it seems that central banks — especially the European Central Bank (ECB) — were reluctant to switch quickly from a “commitment to continue the very low-interest rate policy to support recovery” to a “quick reaction to an inflation risk.” The assumption that quantitative measures — i.e. credit provided to banks — must be abolished before interest hikes also slowed down the necessary policy turnaround. 

At the same time, there was quite an intense public debate taking place in Europe on whether some member countries’ fiscal debt position in the eurozone was relevant for the needed increase of ECB interest rates. 

There are a couple obvious reasons why this was the wrong question. First, since the ECB’s mandate is to preserve price stability, monetary considerations can only play a role if they have clear implications within this mandate — and some countries’ higher cost of debt service is not such a factor. 

More importantly, however, central bank policy that is “behind the curve“ — meaning, interest rates are too low — triggers an increase of longer-term interest rates, leading to higher cost of debt service. Therefore, keeping inflation, and expected inflation, down is the best way to make government debt financing both predictable and cheap in the longer run.  

Finally, there is also the relationship between central banks and politics to consider. The last decades were a good time for central bankers: High inflation wasn’t a concern, and despite the two big global emergencies of the 2008 financial crisis and the pandemic, financial stability — often a central bank’s secondary goal — was preserved. So much so, in fact, that it may have even created the impression that central banking is a simple job. 

The ECB was reluctant to switch quickly from a “commitment to continue the very low-interest rate policy to support recovery” to a “quick reaction to an inflation risk” | Sean Gallup/Getty Images

As a consequence of this stability, the boards of central banks have since changed. Instead of top-class economists like Alan Greenspan or Mario Draghi, or highly experienced central bankers like Eddie George or Paul Volcker, individuals with stronger political skills rather than economic or central bank qualifications took some of these posts.  

Someone with vast political experience can, of course, add value to a central bank’s board, helping them communicate better with both the public and politicians, which is very important. Nevertheless, it’s hard for non-economists or those with limited experience in central banking to understand the complexity of current policy issues and be bold enough to make tough decisions. Even fully understanding the intricate economic analyses or possessing a basic understanding of the models used for producing inflation forecasts can be a challenging task for some board members.  

One could argue that it isn’t a problem if some members lack strong macroeconomic skills, as central bank boards consist of a large group of people. But actually, the opposite is true. Situations where some board members simply follow the prevalence of other colleagues clearly go against the logic of a board’s collective wisdom, which assures better results than a single vote by the governor.   

Overall, by not raising policy rates quickly enough, some central banks — including the ECB — have fallen behind the curve, despite the fact that the complexity of the situation was extremely high and judgements that were seemingly wrong at the time, may now very well be justified and legitimate. 

It’s good that central banks are now trying hard to catch up with the development of the economy, of course. Nevertheless, they still face the challenge of explaining the necessity of bringing interest rates to a much higher level — where they should have been months ago — when there are already signs of recession, which would likely slow down inflation growth and at least advocate for rate stability. But that’s only if they were at an appropriate level to begin with. 

Being a central banker today is an extremely difficult job with great responsibility, making it all the more important than before that we have the right people on their boards. Moreover, central banks should reconsider whether some of these practices they’ve used for many years, restrict their ability to act promptly in the future in order to maintain price stability. 

 The shock that we are currently facing is unique, but it’s definitely not the last one. However, price stability is the unconditional primary goal of a central bank, and this means there is no space for political or fiscal considerations, or unnecessary mistakes.



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