The Conservative Central Banker Returns

BRUSSELS – In recent decades, central bankers’ job had become somewhat boring and frustrating. They were given independence in the 1990s, because that seemed the best way to ensure price stability. The prevailing view (then) was that leaving governments in control of monetary policy would result in economic stimulus that ultimately fueled higher inflation without any appreciable increase in output or employment. The solution was to appoint prudent technocrats whose only task would be to set and adhere to an inflation target.

In one sense, this approach was too successful. Inflation remained subdued for 20 years, and especially after the global financial crisis – an episode that taught central bankers the hard way about the vital importance of financial stability. Price growth did not decelerate by much, even as the economy tanked in 2009 (the so-called “missing deflation puzzle”), and remained low when the recovery slowly gained steam and led to full employment. During these two decades, inflation hovered in a narrow corridor around 2% in the United States, between 1-2% in the eurozone, and below 1% in Japan.

Of course, central banks claimed that this low and stable inflation was the result of their skillful monetary policy, despite the handicap of being unable to push interest rates much below zero. But for an outsider, it remains puzzling as to why, for example, the European Central Bank could not achieve its previous inflation target of “below, but close to, 2% over the medium term,” despite implementing a bond-buying program worth trillions of euros.

The ECB’s own research purports to show that the bank’s asset purchases (quantitative easing) were very effective. But this raises the question of whether a few hundred billion euros more would have achieved the inflation goal. Moreover, a critical review of central bank research suggests that quantitative easing was not as potent in fighting deflation as some made it out to be.

It thus seemed that the ability of monetary policy to push up inflation to exactly 2% was limited. For central bankers, this was a source of frustration. But the public did not care much, because deflation was never a live danger, and consumers do not really feel the difference between an inflation rate of, say, 1.2% and 2%. The longstanding absence of serious concerns about price stability may have been one reason why central banks recently ventured into other fields, like greening their monetary policy.

Furthermore, because inflation had run slightly below target for many years, both the ECB and the US Federal Reserve updated their monetary-policy strategies. Earlier this year, the ECB adopted a new symmetric 2% inflation target. And in 2020, the Fed stated explicitly that it would allow inflation “moderately above 2% for some time” if it had been persistently below this level previously. Moreover, the Fed, whose dual mandate includes promoting maximum employment, added that it would aim at limiting “shortfalls of employment.”

But the era of stable low inflation that prompted these changes has suddenly ended. Inflation is now increasing sharply on both sides of the Atlantic, owing to the combined impact of massive fiscal stimulus, a stronger-than-expected recovery of private demand, supply constraints stemming from logistical bottlenecks, and higher energy prices.

In the eurozone, inflation jumped to a multi-year high of 4.1% in October and to 4.9% in November, the highest since the euro’s introduction. Even core inflation, which strips out volatile energy and food prices, is now 2.6% and rising. US inflation is even higher, with annual consumer prices increasing by 6.2% in October.

The new ECB and Fed strategies now look like a case of adapting the general staff manual to fight the last war. Fortunately, there are some signs that policymakers are ignoring these approaches, and that conservative instincts are returning.

In the US, this is already clear. Only days after President Joe Biden reappointed him to a second four-year term, Fed Chair Jerome Powell indicated that inflation was becoming a real danger, requiring a quicker end to the Fed’s bond-buying program. Policymakers no longer mention limiting “employment shortfalls,” because aiming for high employment levels makes little sense when millions of people have voluntarily left the labor market.

The Fed thus seems to have pivoted back to traditional inflation-fighting mode in the space of a few weeks. In the eurozone, change comes more slowly, partly because the ECB’s decision-making process involves far more people. The ECB Governing Council has 21 voting members (out of a total of 25), compared to only 12 for the Federal Open Market

Committee. Moreover, the eurozone’s inflation overshoot is more limited. But even here, one must ask whether emergency bond buying is still needed today.

It is too early to tell whether low inflation will return soon. For now, however, central bankers must again concentrate on their traditional task. The high inflation of the 1970s also started with production bottlenecks and rising energy prices, and became endemic because policymakers spent too long hoping price pressures would remain transitory. Today’s central bankers have to relearn that difficult lesson.