We’ve Been Lying To Ourselves About Central Banks And Inflation

Investors eyed Jerome Powell’s first day of Congressional testimony on Wednesday. Traders were “bracing for Powell,” to quote a somewhat inane headline.

Spoiler alert: Powell will reiterate the Fed’s commitment to the inflation fight. That commitment is now “unconditional,” according to the obligatory report prepared for lawmakers ahead of his trip to Capitol Hill.

He’ll also be compelled to explain how the technocrats managed to get things so wrong. I have a modest suggestion. They didn’t get it “wrong,” because to suggest as much is to tacitly assume that they had it “right” previously — to assume that the decline in macro volatility over the past several decades (figure below) was in large part attributable to independent central banks with inflation mandates. I don’t think that’s true. I don’t think they ever had “control” over inflation in the first place. Inflation is a phenomenon, not some setting that can be fine-tuned by dialing up other settings.

Those who argue developed market central banks can “absolutely” create and extinguish inflation in the real economy generally rely on the most extreme examples to make the point. If the Fed sent everyone checks for $5 million directly, the US would have hyperinflation, they studiously note, as if that’s a revelation. Paul Volcker, they’ll say, “tamed” inflation through a resolute, unwavering campaign of painful, but ultimately necessary, rate hikes, and we should all thank him for it. A less flowery retelling is that Volcker bludgeoned inflation into submission by way of a singleminded, unapologetically doltish commitment to undercutting the economy.

To call any of that “control” is a ludicrous stretch — like saying I have control over a dog because I can whip it into a feral frenzy by feeding it three pounds of hamburger meat then quickly bring it to heel by firing a shotgun through the ceiling.

In-between extremes, central banks never have control over prices. Time and again I’ve suggested that, when we recap the hyper-globalization years and the Great Moderation, we may give central banks too much credit. In the grand scheme of things — taking account of well-documented trends in demographics, debt and technology, as well as the disinflationary impact of wave after wave of globalization — it’s not obvious that central banks deserve anything more than a polite acknowledgement in a footnote.

Is it realistic to suggest that small panels of technocrats were more influential in shaping the macro landscape over a four-decade period than globalization, demographics, technology, offshoring, deregulation and the corporate profit motive combined? To me, that seems laughably implausible. And yet analysts and economists make that argument every, single day in one form or another.

As I put it last month, an alternative history of central banks’ contribution to disinflation post-Volcker might assign more credit to the spectacular busts they inadvertently facilitated than to political independence, forward guidance or inflation targeting. How ironic would that be?

Macro developments in 2021/2022 shook the idea that central banks ever had control over inflation to the core (no pun intended). The pandemic upended several key deflationary trends and within months, inflation became unanchored. Yes, policymakers waited too long to hike rates, but to call developed market inflation a “monetary phenomenon” is to give oneself completely over to theory while abandoning common sense entirely.

Thomas Barkin spoke to some of this on Wednesday evening. “We are now two years into an unstable economy. It seems highly unlikely you go from very stable to very volatile to very stable again,” he said, while chatting with reporters after a speech in Richmond.

Having addressed the issue tangentially, he confronted it head-on. “I’m concerned that our success in managing inflation over the last twenty years was partially enabled — it was good policy but it was also tailwinds which were disinflationary,” Barkin mused.

And just like that, a Fed official tacitly and gently admitted to the possibility that this was always a charade. He didn’t couch it in those terms, of course, but the overarching point is the same. It’s possible that central banks played, at best, only a supporting role in containing inflation and facilitating the decades-long decline in macro volatility.

Barkin was quick to reclaim what he conceded. “That doesn’t mean you can’t control inflation,” he said. “We’ve got a mandate. We’ve got the tools.”

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20 thoughts on “We’ve Been Lying To Ourselves About Central Banks And Inflation

  1. Great points about Corporate America’s involvement in inflation. I’m not sure why they always get a pass for the actions they take that impact our lives, but they always seem to. The angry Midwestern Trumper who blames Democrats for why he and his entire family are now jobless and poor never blames the manufacturing company that offshored his job and closed his plant. Americans paying astronomical prices for food at the grocery store find it easier to blame Biden than Kroger who is absolutely taking advantage of inflation to increase profits.

    1. It’s a argument, but I don’t know if it’s a great one. The problem with abolishing central banks is that you run a very high risk of recurring deflationary meltdowns. Gamblers are going to gamble irrespective of whether there’s a backstop. Just ask any family man who squanders the kids’ college money on a Vegas trip. When those bets blow up, and there’s no “dealer of last resort” (to use Pozsar’s reimagined Bagehot), you’ll have episodic bouts of cascading collateral contagion. That’ll spill over onto Main Street as lending contraction. The idea (implicit in any “good” “reset” narrative) that banks will then learn their lesson and stop gambling is like suggesting that someone who was cavalier enough to gamble the kids’ college money won’t do it again.

        1. Well, yes. Of course it is. We have an economy built on financialization that allows someone with $50,000 to finance a mini-mansion and that allows someone with a 650 credit score to lease an E-Class and that allows people with no money at all to borrow thousands on plastic cards to buy 70-inch flatscreens and on and on.

          That’s only possible because of financialization, securitization and layer upon layer of abstraction. Banks create, facilitate and maintain those layers. Because almost no one can, strictly speaking, “afford” the things they buy, the system needs a backstop.

          What is credit? Basically just faith in a better future. That’s a gamble. If that faith turns out to be misplaced, and the gamblers get burned, they have to be backstopped.

          If you think that’s a problem, or that it’s intolerable, you can express your opposition to the system by paying cash for the next home you buy.

          1. Or at least putting a significant (30%+) deposit.

            Which isn’t the worse idea in the world. France does that. It does make home ownership harder but life’s purpose isn’t just to buy a home…

          2. Considering the majority of Americans can’t buy a homeI’m not sure how convincing an argument that is. If financing wasn’t as readily available today’s down payments might be closer to closing prices.

            The more interesting point here is the explicit eschewing of the dual mandate. If the public were to believe the dual mandate is smoke and mirrors the ‘backstop the banks’ argument will almost certainly fall on deaf ears.

          3. “If the public were to believe the dual mandate is smoke and mirrors the ‘backstop the banks’ argument will almost certainly fall on deaf ears.”

            Until credit contracts and the public realizes that without the backstop, you actually have to have money to buy things. Then they’d be all ears.

        2. The US does have a history without central banks (1837’s free banking era of State banks), as I understand it they’re a necessary evil of a pressure valve (or Mr H’s backstop).

          They’ll let some losses occur but prevent society from collapsing; people who suddenly lose everything through no fault of their own is an unnecessary risk worth insuring.

          Their current inflation and employment mandate is an interesting proactive extension of that mission of stability (conversely hyperinflation or Depression lead to chaos and violence).

  2. Seems that inflation can best be described as a symptom, but of what? Like a rash, there are maybe 100 different causes, some internal and some external. Like a rash, auto-suggestion can make it worse or better. Now all the docs are crowded around looking at your rash, focused more on how it looks instead of what’s causing it. All I know from my past experience is I might wake up tomorrow and it’s gone or maybe it’s worse, but most likely it hasn’t changed.

  3. The monetarists believe otherwise. I am with you H. Monetary policy is one of many ingredients that can effect inflation- often there are overiding structural, political and demographic causes as well. If you are ignorant it is easy to blame a politician or FOMC chair for inflation. Reality is much more complicated. See SF Fed study cited on Bloomberg which suggests supply chain issues are responsible for roughly half the inflation we are now experiencing. So that 8.6 headline is more like 4.3% from policy, and 4.3% from other factors. I would say that is one reason that bond yields are still much lower than headline inflation would suggest they should be. (base inflation is less than 4% core).

    1. The bottom line (and any monetarist who denies this is subjugating reality to theory) is pretty straightforward: At any given moment, extreme exogenous shocks can render monetary policy totally ineffectual on either the inflation side or the deflationary side. Structural trends can do the same thing over time. If the Kremlin cuts off 100% of gas flows to Europe tomorrow, prices are going to go through the ceiling and the ECB can’t stop it even if they held an emergency meeting and hiked rates to 40%. Demand destruction would set in on a lag and a 40% policy rate would quickly manifest in a Depression, but, again, that’s not “control.” The assumptions we make about money, the economy and really just life in general, all assume no substantial exogenous shocks. In the face of such shocks, all our assumptions and theories are totally irrelevant. That seems obvious. But my contention is that we forget it all the time.

  4. H – to be fair, you could argue the Fed was being fairly powerless to control inflation from a lot earlier. And we generally did.

    After all, for more than a decade post 2008, they tried and failed to generate inflation. Demographics, innovation, globalisation etc. may all be reasons why. But a lackluster fiscal response due either to misguided austerity worship (Europe) or Republicans hatred of a Black Democrat President (the USA) would have to figure prominently in the explanation, no?

  5. “If economic survival is always taken for granted, the rules of behavior applicable in an uncertain and ruthless world cannot be discovered.” – Andrew Roy

    1. Bingo, this is exactly what I was going to say. Not only will they choose the over-simplified story, but they’ll also choose the story that reflects what they want to believe which conveniently assumes everything good is a result of their actions and everything bad is the result of external factors.

  6. H- dear god, I certainly hope you don’t have a dog!
    I don’t know what made you visualize that episode with a dog, but I found that paragraph hysterically funny. Fwiw, I love dogs, so that really got my attention.

    As far as the Fed, all I can think of when they refer to their tools is “up to eleven”!!!

    Great post. I am definitely a believer that we are still in the long term deflationary trend. Currently experiencing a bump in the road, so to speak

  7. H

    Two things. First, you said, ” I don’t think that’s true. I don’t think they ever had “control” over inflation in the first place. Inflation is a phenomenon, not some setting that can be fine-tuned by dialing up other settings.” This is not only true but very important. Inflation is not a thing in and of itself. Rather it is a single word used to summarize the outcome of millions of individual behaviors happening at roughly the same time. Sick is not a thing, either, it is a similar summary word used to describe the outcome of many different things going on in one’s body. A person is sick if s/he has a cold or measles or cancer. Still sick. Inflation happens when many behaviors combine to make the general level of prices for goods, commodities, labor, etc. rise, as in the economy may be said to be sick.

    Volcker didn’t come along with his monster rate shillelagh until high prices had be wreaking havoc for the better part of a decade. We’d already gone through Nixon’s price controls and other fails. Hell, can we even prove that Volcker actually fixed anything?

    1. Having spoken to my parents indeed having the Fed at 20% meant people absolutely did not buy large purchases on credit and money was scarce. It changed behaviors and mindsets, much like the Depression.

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