What if there is nothing central banks can do about inflation?

Receive free Global inflation updates

We’ll send you a myFT Daily Digest email rounding up the latest Global inflation news every morning.

There is a concept in the social sciences — including economics — that policymakers and those who advise them would do well to bear in mind: observational equivalence. This is when several rival explanations of what is going on are compatible with everything we are able to observe. In such cases, basing policy on a theory that fits the data (until it suddenly doesn’t) runs the risk of some nasty surprises for which we are unprepared if we don’t pay sufficient respect to the possibility that a rival explanation is the correct one.

This came to mind as I was following the European Central Bank’s top central bankers’ retreat at Sintra in Portugal last week. It took place at an exquisitely difficult time for central bankers, when overall inflation is falling quite rapidly but remains too high for comfort. Uncertainty was the name of the game at Sintra — uncertainty about how fast inflation will decline, how much effect on economic activity is still to come from the interest rate rises we have already seen, and as a result, what is the right policy to pursue now.

Despite acknowledging these deep uncertainties, however, the central bankers were keen to project certainty about their policy. The general message was that inflation is proving persistent, so don’t expect a softening of monetary policy any time soon — indeed, rates may have to go higher and stay there for longer than people expect. Bank of England governor Andrew Bailey, for example, commented: “I’ve always been interested that markets think that the peak will be shortlived in a world [where] we’re dealing with more persistent inflation.”

There is a puzzle here. How does rising uncertainty make policymakers more, rather than less, determined? Before Sintra, Adam Tooze analysed how accepting relative ignorance shapes the new logic of inflation-fighting in counter-intuitive ways. Tooze was responding directly to a speech given on June 19 by Isabel Schnabel, an influential member of the ECB’s executive board, in which she argued that “if inflation persistence is uncertain, risk management considerations speak in favour of a tighter monetary policy stance”. The notion that greater uncertainty justifies tighter monetary policy is an argument Schnabel has been developing for some time, and this intellectual work is as good an explanation as any for the stance most central bankers have adopted.

Central bankers are now openly distrusting their own forecasts. Schnabel draws on research showing that forecast errors are correlated to suggest that she and her colleagues are more likely to underestimate than overestimate inflationary pressures, since they already did so last year. That is one reason given for redoubling efforts on tight monetary policy. The other is a belief that it is easier to correct a stance that proves excessively tight than to undo the damage of doing too little to push inflation down.

But as Tooze argues, whether this is the case surely depends on what the costs of excessive tightening would be. I would add that the whole argument for “robustness” also depends on what precisely the counterfactual to inflation persistence is. Any “relative cost of getting it wrong” analysis hinges on what precisely “getting it wrong” means. Supporters of tightening should therefore give serious consideration to the explanation of inflation that most undermines their position.

That account is this: inflation is at present coming down by itself; not because of monetary tightening but because the supply shocks that pushed up prices in the first place have been going into reverse. By also reversing any original deterioration in the terms of trade (the additional external deficit in economies that are net energy importers), that makes it possible to restore initial real wage levels. Monetary tightening, meanwhile, affects real economic activity with a lag and has yet to affect price formation much. So the tightening comes too late to do any good, and will only add to (downward) price instability once inflation has returned to target by itself.

Suspend, for the moment, your judgment of whether this is probable; focus on the fact that it is possible. The behaviour of prices is compatible with this explanation. The last big supply-side shock was the big jump in global (and especially European) wholesale energy and food commodity prices from February to June last year. Year-on-year inflation peaked that June in the US, and in October 2022 in the eurozone, in the UK and in the OECD as a whole — all but three of whose members saw inflation fall last month. Wages are still catching up with past inflation rather than leading it.

It is true, of course, that “non-core” inflation (prices excluding food and energy) and services inflation (which is more domestically generated) are coming down more slowly than central banks had hoped for. In addition, inflation expectations are a little bit higher than before: in the eurozone surveys find that people at present typically expect inflation at 2.5 per cent three years from now.

But this is why observational equivalence matters. As I described a few weeks ago, there is solid analysis that can account for virtually all the behaviour of both US and eurozone inflation as just what the temporary repercussions from sector to sector of a series of large supply shocks would look like. Expectations data, too, fits the possibility that people’s expectations are shaped by the inflation they currently see, so that as headline inflation keeps falling, so will expectations. In the US, inflation expectation estimations that followed current inflation on the way up have followed it in lockstep back down from the peak. The Federal Reserve Bank of Cleveland’s inflation expectations measure is now below or at the 2 per cent target for all time horizons.

You are seeing a snapshot of an interactive graphic. This is most likely due to being offline or JavaScript being disabled in your browser.

So consider what else would be true if this is in fact the true explanation of events. One implication for central banks is particularly significant: that there was nothing monetary policy could have done to prevent the bursts in inflation of the past two years, and that current monetary policy is contributing nothing to inflation coming back down. This does not mean interest rate rises have no effect, but that the effects will be exclusively harmful, because they will depress the economy — killing income and jobs growth — when inflation has already disappeared. Put simply, if this is the right explanation of the data we see, the only thing central banks are able to do is to make things worse.

We can expect several retorts to this reasoning. One is that even if there was nothing central banks could do to reduce inflation in the relevant timeframe, they must still act as if they can in order to prevent expectations from drifting up. But the hypothesis to be addressed is that they cannot even do this (again, in the relevant timeframe, after which it will be counter-productive). Another retort is that even if central banks can’t do anything about a burst of inflation until it has come and gone, they can bring inflation down below target for a while after that — and it would reinforce on-target inflation expectations if people thought any high-inflation period would be followed by a depressed, low-inflation or even deflationary one, courtesy of central banks. But this would be saying that central banks should amplify fluctuations in inflation — quite the opposite, one should think, of pursuing price stability.

The case for “getting the job done” in terms of tightening, therefore, has to come down to the improbability of this explanation being correct. But what do you base this on in the case of observational equivalence? Presumably by being actively on the lookout for data that is able to “break the tie” between alternative explanations. (For example, compare the sector-to-sector transmission of both price increases and price falls.) And presumably not by taking for granted the explanation that tightening came too late but is now working, and that the question is simply how much more of the right medicine to apply.

An inflation hawk may be tempted to argue that since a central bank’s exclusive job is to ensure stable prices, all this doesn’t matter: it should just do all it can to lower inflation. But this is wrong in the case of central banks that have dual or mixed mandates, including the ECB for which inflation takes absolute priority. For if tightening does not have an effect on the current inflationary episode at all, then the policy should be judged on how it helps — or, rather, how it harms — its secondary mandate of supporting the EU’s other economic policies. Besides, price stability, of course, requires avoiding below-target outcomes as much as above-target ones.

Accepting there is nothing you can do is hard for any policymaker. But “do no harm” is also a useful principle.

Other readables

• The path to economic security for the EU goes through building a big and growing green-tech market right at home.

• The Bank for International Settlements has long been at the forefront of imagining how to make the monetary system fit for the future. Its latest report makes an important recommendation for a new type of monetary infrastructure: a “unified ledger” that would allow decentralised “tokens” or digitised financial claims to be connected to one another via central bank digital currencies. As the BIS puts it, this “opens the way for entirely new types of economic arrangement that are impossible today due to incentive and informational frictions”.

• Toyota has made tantalising promises about its solid-state battery technology; my colleague Leo Lewis kicks the tyres.

• Ukraine urges other countries to follow the EU’s longer-term funding pledge.

Numbers news