By Charles Goodhart, Emeritus Professor in the Financial Markets Group, London School of Economics, and Manoj Pradhan, Founder, Talking Heads Macroeconomics. Originally published at VoxEU.
The current mini-surge in inflation is forecast to return to central bank targets towards the end of 2022, or shortly thereafter. However, there is also a risk of inflation remaining persistently high for longer. This column discusses the implications of such a contingency for central banks and monetary policy. The authors warn that sudden policy reversals could lead to severe downturns in financial markets and significantly damage public sector balance sheets. Instead, they call on central banks to develop concrete plans for dealing with persistently higher inflation, with a particular focus on their balance sheet policies in a world of rising nominal interest rates.
At one point during the ECB’s recent Sintra Conference, a prominent central banker spoke about ‘longer-lasting transitory factors’; meanwhile, the adjective ‘transitory’ is becoming replaced by ‘temporary’. Although central banks have slowly and painfully been giving ground on forecasts both for the scale and duration of the current mini-surge in inflation, they, and most mainstream economists, remain in denial that it could become a more persistent feature of future years and decades. Inflation projections have been ‘marked to market’ to reflect the higher inflation prints we have seen, and some persistence has now has also been added. However, inflation is still forecast to return to central bank targets towards the end of next year, or shortly thereafter. In other words, it is still ‘transitory’, just for a bit longer (Ha et al. 2021). Let us fervently hope that they are right.
But what if they are wrong? What might happen if, say by mid-2022, there is little sign of inflation retreating from its end-2021 levels (of about 4-5% in Consumer Price Index (CPI) for all of the US, UK, and EU), with expectations of future inflation trending slowly up at all horizons, continuing shortages of labour, and workers, even where there are no shortages, demanding higher pay to compensate for both past and expected future inflation (e.g. Voinea and Loungani 2021, Ball et al. 2021).
Would it then be right to leave real interest rates at significantly negative levels, with unemployment trending downwards (who knows what the equilibrium natural rate might be), a growing need for infrastructure and green investment, and public sector deficits still historically elevated? Financial markets are currently expecting the Federal Reserve, for example, to start raising policy rates as early as September 2022, with four or five hikes of 25 basis points over the course of 2022-23. Breakeven inflation rates (the difference between nominal yields and inflation-protected securities) in the US at the five-year horizon are hovering around 2.7% (note that the two-year breakeven rate is higher, not lower, than the five-year, so we are being conservative with our measure of expected inflation). So markets appear to be comfortable with the real policy rate remaining persistently negative over the next few years.
So how will central banks react if, and when, they begin to discover that their forecasts and models have been systematically wrong? The most worrying possibility is that central banks might reverse policies suddenly and dramatically, with a 180-degree course correction entailing 50 basis point hikes and shrinking balance sheets. One can see only too easily how this might happen. After months, some of us might say years, of getting forecasts and policies wrong, central banks might feel that their credibility is at stake. Having stated that they were supremely confident in their ability to control inflation, they might feel forced to try to demonstrate that capability quickly and suddenly. What this might mean in practice could be a rapid shift from a policy of glacially slow increases in nominal rates, plus a very slow taper of quantitative easing (QE), to one of increases in nominal interest rates of, say, 50 basis points per meeting, and no replacement of maturing central bank holdings of QE-related debt.
But such a sudden shift of policy would be horrendously risky. Such monetary tightening would likely cause a rapid collapse in asset prices, including bringing to an end the world’s most coordinated housing boom. In view of the additional debt and high leverage of the private non-financial corporate sector, it could cause a steep rise in bankruptcies and non-performing loans (NPLs). We could get a depression of an awe-inspiring scale. The effect on the public sector balance sheet would be devastating. Tax revenues would fall, while public sector expenditures and debt service would rise sharply.
Under these circumstances, there would be no advantage or case at all in reversing course so sharply that inflation became replaced by deflation. There are many worse outcomes than a few years of moderate inflation, say in the 4% to 5% range. Even if central bank credibility takes a knock, one could always blame unforeseen events and/or the policies of predecessors.
So what should central banks now do against the possibility that moderate inflation becomes more persistent and increasingly engrained in the system?
The first need is to have a plan about what one might do under such circumstances, even if such a scenario is still thought unlikely. The Bank of England is to be greatly applauded for having worked out such a plan, and it makes sense. Indeed, it would be good to start putting that plan into operation, with a symbolic tiny increase in nominal interest rates in the immediate future.
Next, central bank economists need to start thinking about the effect of rising nominal rates, at the same time as real rates remain strictly negative. With higher and more persistent inflation, it will take some time for a slow increase in nominal rates to bring real rates back to zero; but rising nominal rates on their own will have significant effects not only on financial markets, but also on the real economy. In these conditions the concentration on r* is misplaced. The rate of change of nominal interest rates will be an important factor affecting the economy on its own, even when real rates remain strictly negative.
In addition, central banks may find themselves having to think harder and quicker about their balance sheet policies, and the form of their monetary operations (see also Cecchetti and Tucker 2021).
A floor mechanism for setting interest rates, plus quantitative easing, had many advantages during the years after the Global Crisis. Not only was it easy to manipulate, but it provided commercial banks with a huge buffer of liquidity, thereby making them much more resilient in the face of the Covid-19 shock. But when nominal interest rates start to rise, the disadvantages, in some large part political, of this technique will become increasingly apparent. At a time of worsening debt service ratios, the need for increased taxation and the transfer of increasingly large payments from the public purse to commercial banks for holding reserves at the central bank will become increasingly politically unpopular, not to mention the adverse effect on central bank profitability. You do not have to be a populist politician to see how this conjuncture could become widely unpopular, and difficult to defend.
So, central banks need to consider what their balance sheet policies should become in a world of rising nominal interest rates, and whether the current structure of quantitative easing and the massive availability of additional liquidity is still going to be optimal in such a different situation. First, central banks will have to bear capital losses on their holdings and could need recapitalisation from governments. That process will have to be structured in a way that does not raise questions about central bank independence (see Allen et al. 2021). Second, many of the quasi-fiscal uses of quantitative easing (such as propping up mortgage-backed securities (MBS) markets when they had assumed macroeconomic importance) will have to be unwound. Finally, over a structural horizon, as age-related government debt rises, central bank balance sheets are more likely to expand than shrink. The balancing act will be about avoiding the creation of moral hazard by monetising too much of the debt, versus doing so little that markets push interest rates higher because of concerns surrounding the financing of this debt.
And, through all of that, central banks need to pull these policies together in a way that convinces financial markets that an orderly evolution is not just possible, but likely. In other words, fighting the right war is difficult enough. Fighting the last war would be a catastrophe.