All the major global central banks have an unhealthy fixation on the narrowest of data points. They all set policy according to the lodestar of inflation being at 2% in the medium term.
That has always been bizarre since the world doesn’t work to such order. They can’t calculate it properly anyway — as the current rampant inflation spike shows.
So it’s time for these rigid targets to be scrapped and for more flexibility to be breathed into monetary frameworks. Urgently. Otherwise we will be fighting the last war with outdated weaponry. The Fed flirted with a more realistic approach under its short-lived Flexible Average Inflation Targeting but dropped it like a stone on the first signs of (serious inflation) grapeshot last year.
There has been some thought given to commodity price surges but
so far no real action in changing the simplistic and likely flawed way
of just looking at the forward futures curve. There is a worrying
disconnect, as we are literally waiting for it to happen to us before waking up
Central bankers throw their hands up in despair when external price shocks, such as we have seen in oil and gas, make their forecasts look as if they’ve been at the sherry. They console themselves that if, say, oil stays at $100, then they can say it’s simply transitory: Next year’s price data shows no ongoing inflation. Even better if oil falls: Presto, they could be running under target.
The pervading economic influences this century so far have been deflationary: globalization, technological advances, China’s vast exporting machine and aging populations. But what if the world really has changed? Bond yields have been on a steady downward trajectory for a generation. It has led to navel-gazing inflation modeling that largely excludes the food and energy measure, removing the volatile elements. Those are the bits we need to look closest at now. Trouble is, little of what we’re facing in the post-COVID-19 world is in an econometrics textbook — the source of most central bank research methods.
What happens if oil goes to $150, and then $200 over the next few years? And the rest of the commodity complex follows in line? Then whatever monetary authorities think they can control starts to become borderline pointless. They may still have their hands on a steering wheel, but it’s a child’s version attached in the back seat.If you can’t master externalities, then it follows you have to overdo the stuff you can tinker with. Whisper it, but if their precious 2% target stays, then it means having to cool the labor market at home. Translation: higher interest rates, higher unemployment. So what gives first, civil unrest or some reactive outdated model?
The first waves of quantitative easing from the Federal Reserve, along with major stimulus from China, contributed to a doubling of the CRB commodity index from early 2009 to early 2011. That caused central bankers to go back to the drawing board, but subsequent rounds of QE have not led to sudden clarity about the effect of withdrawing stimulus. Quantitative tightening is going to be very tentative at the start. The Federal Reserve is still adding QE, so the overall stock of stimulus is going to be with us for decades more.
What we are left with is a collective global central bank balance sheet several tens of trillions of dollars larger, extensive research on negative rates but still confusion about how to even include house prices in inflation data. We are not starting from a good place, with the correct expertise, to comprehend sustained food, energy or wider commodity price inflation.
There has been some thought given to commodity price surges but so far no real action in changing the simplistic and likely flawed way of just looking at the forward futures curve. There is a worrying disconnect, as we are literally waiting for it to happen to us before waking up.
Perhaps this is all just rearranging the deckchairs. Targeting the cost of living is central banks’ primary purpose, but for whom? With asset price booms over the past decade, certainly not the bottom 50. And that’s before we grapple with the consequences of climate change and meeting net-zero targets. To be fair, European Central Bank executive board member Isabel Schnabel has again flagged the need to start thinking about the green transition. Sadly, she is the only central banker yet to tell us the truth. But to give you a clue if we want climate action the 2% target is going to have to give.
Beyond that, what do you plug into your mathematical spreadsheet for the dynamic political instability of the current conflict in Ukraine? Suddenly this has become a fundamental driver for food (grain, corn) and energy. Equally, China eased off industrial production as it showcased itself to the world for the Winter Olympics but with commodity stockpiles still low globally, especially for iron ore, it has the ability to upend the commodity apple cart on its own and its domestic economy sure needs reviving.
Sure you can’t just blame poor economists furiously adapting their models, but we can’t just accept “computer says no” either. Time for the monetary wonks to get out of their own way. Stop focusing on a number of one economic input, think flexible ranges and counter-cyclical proactive measures. Fiscal as well as monetary.
Central bank independence is lauded as the crucial ingredient for combating inflation, but they are duty bound to fixed policy targets set by their political masters. The response to digging us out of the pandemic hole has been so successful because of the coordination between governments and monetary authorities, but it has led to unforeseen inflationary consequences. Time to rethink the construct of interdependence and drop the stupid targets. Adapt or perish.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Source: Bloomberg