Mismanagement of inflation expectations
By Howard Davies/Edinburgh
Central bankers are not required to be great wordsmiths. The ability to write elegant paragraphs is not normally part of their job description. Until recently, many prominent monetary policymakers operated on the principle of “least said, sooner fixed”.
Montagu Norman, the Governor of the Bank of England (BoE) from 1920 to 1944, lived by the motto “never explain, never apologize”. Similarly, former US Federal Reserve Chairman Alan Greenspan once proudly observed that he had “learned to mumble with great incoherence.”
But these views are now outdated. Senior BoE officials gave, on average, a total of just 13 speeches a year in the 1990s. Over the past decade, the average was over 80 and the trend line is pointing up. A similar trend can be observed in other central banks.
It’s not because central bankers now aspire to be public figures; in private, many would prefer the Norman approach. But an inflation targeting regime is believed to work through clear and credible management of expectations. Convince economic actors that you will hit your target most of the time, and they will do some of your work for you by moderating their wage demands and keeping prices stable.
Thus, communication between central banks is important; for monetary policy makers, it is not an optional feature. And their experience over the past few months has been unfortunate. As recently as September, Fed Chairman Jerome Powell was telling the world that the rise in inflation, which began to be felt last summer, was “transitional”. The word was picked up by the President of the European Central Bank (ECB), Christine Lagarde, and in November it was still widely used in the Western world.
But by December, with US inflation at 7%, the message had changed and “transitional” was out of fashion. Powell was now telling us it was “probably a good time to retire that word”, while US Treasury Secretary Janet Yellen, his predecessor at the Fed, acknowledged that “it was not an appropriate description”.
Rarely has a financial term had such a short lifespan. The “transient” is now buried in the lexicographic cemetery of central banks, along with “forward guidance”. Sic transit, as the Romans would say.
Does this embarrassing and abrupt linguistic reversal matter? I’m afraid that’s the case.
Speeches are only part of the communication mix used by central banks to influence inflation expectations. Monetary authorities have also enthusiastically embraced social media, including Twitter, where the Fed currently has over 800,000 followers, and the ECB over 650,000, for feeds that regularly extol the virtues of low inflation.
But worrying new evidence shows that this message is not getting across and that central banks are not as trusting as they would like to think. In fact, less than 20% of US households are aware that the Fed is targeting a 2% inflation rate. Remarkably, almost 40% believe it is aiming for inflation of 10% or more.
Many also believe that inflation has recently been higher than official statistics indicate. Here, some of them might be right, because different social strata face different inflation rates. For example, rising food and energy prices disproportionately affect the poorest households.
Central banks like to focus on so-called core inflation, which excludes short-term factors – in particular, increases in food and energy prices – that monetary authorities cannot. control. This may lead policy makers to regard a rise in inflation as “transient”. But consumer price expectations, on the other hand, are shaped by the rate of inflation they have actually experienced, and food and energy costs are an important component of many household budgets.
This is probably why US consumers and households believe that inflation in the coming year will be higher than US economists believe. Economists predict an average inflation rate over the next year of 3.7%. Business leaders expect it to be a little higher, at 4.1%, while households expect prices to rise by 4.7%. Households’ medium-term expectations are also higher. This pessimism will certainly influence wage demands, as is already evident.
Who will be right? We will know soon. Central banks can put forward convincing arguments suggesting that inflation will decline next year. For example, despite higher cooling demand, energy costs generally decrease during summer in the Northern Hemisphere.
But the outlook for energy costs is highly uncertain and is influenced by unpredictable geopolitical risks, not just supply and demand, which can more easily be modelled. The most useful indicator in this regard might be the number of Russian troops massed on the Ukrainian border, which is not a statistic that central banks normally collect.
For now, the position of central banks is not hopeless; hyperinflation is not around the corner. The Fed can argue that the price level is simply back to where it would have been had policymakers precisely hit an annual inflation target of 2% every year since 2000. In the Eurozone, prices are still 10% lower at this level.
But the cost of losing control of consumer inflation expectations, which major central banks appear to have done, could be high. The evolution of wage settlements over the next quarter will be decisive. If wage increases accelerate, central banks will be forced to react strongly or lose even more credibility, so interest rates will rise as economies still struggle to emerge from the pandemic. It is fortunate that Powell was recently reappointed as he may not win any popularity contests in 2022.
— Project syndicate
• Howard Davies is Chairman of the NatWest Group.