The writer is a former central banker and a professor of finance at the University of Chicago’s Booth School of Business
Why is the US Federal Reserve finding it so hard to convince the market that it means business when it comes to not cutting rates? The December meeting minutes stated clearly, “No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.” Yet this hawkish statement did little to shift market expectations, making the Fed’s job of slowing the economy harder.
Central bank statements have influence because people still believe the institutions will do what they say. And such credibility is obtained through a mix of central banker reputations (either as doves or hawks), past actions, the policy tools they have and the frameworks they operate under. Unfortunately, the kind of credibility needed to escape a regime of overly low inflation, which we had until recently, is different from the kind needed to curb high inflation, which we have now. And by its very nature, credibility does not turn on a dime.
Traditionally, central banks grappled with high inflation. Government spending typically overstimulated the economy to generate growth. Central banks aided and abetted this, not just by holding rates low, but by financing government spending. In the process, they managed to fuel inflation, which hurt growth as it became entrenched. Then, perhaps learning from the Fed under Paul Volcker, countries decided it was better to have an independent technocratic central bank, mandated to keep inflation under control through an inflation-targeting framework. And so the banks gained credibility as inflation fighters.
But after the global financial crisis, inflation fell too much, making the challenge pushing it back up. In order to boost inflation, central banks had to develop a new kind of credibility. In the phrase of economist Paul Krugman, they had to “credibly promise to be irresponsible” when they saw inflation, by committing to hold back rather than fight it ferociously.
And so central banks embraced a new set of tools. Quantitative easing, for example, whereby the bank announces it will buy government bonds for an extended period, worked in part by committing the bank to not raise rates until it came to the end of its announced purchase programme. Indeed, this may be part of the reason both the Fed and the European Central Bank were slow to raise rates when inflation picked up in late 2021. Central banks also acted in ways that undermined beliefs about their rate-raising resolve, as when the Fed stopped rate increases after markets started swooning in late 2018.
Finally, central banks changed their frameworks to embed inflation tolerance within them. A key element of the Fed’s new framework, adopted in 2020, was that it would no longer be pre-emptive in heading off inflation. The old mantra, that if you are staring inflation in the eyeballs it is already too late, was abandoned.
While none of this was particularly effective in moving inflation higher, it may have emboldened the government to spend more, knowing the central bank would not raise interest rates quickly. When the pandemic hit, there were few constraints on government spending which, together with the war in Ukraine, pushed us back into a high-inflation regime. But central banks again find themselves with the wrong kind of credibility — namely the assumption that they will tolerate inflation. No wonder markets continue to price in Fed cuts, even as the Fed insists it will not turn accommodative until inflation is tamed. In sum, central bank credibility is only useful when appropriate for the inflation regime it faces.
Should the Fed work once more to regain credibility as an inflation hawk? Credibility takes a long time to build, and inflation regimes could switch again. It is not unthinkable that ageing populations, low immigration, deglobalisation and China’s slowing will plunge the world into a low-growth, low-inflation environment once more.
Nevertheless, central banks will probably be most effective if they rebuild their commitment to combating high inflation. And if inflation falls too low, perhaps we should learn to live with it. It is hard to argue that all the frenetic activity in the recent low-inflation regime was effective, and it distorted credit, asset prices and liquidity in ways that are hurting us today. But so long as low inflation does not collapse into a rapid deflationary spiral, central banks should not fret excessively. Instead, they should put the onus back on governments and the private sector when it comes to generating sustained growth.
