The politics of monetary policy
Central banks are in the process of shifting their attention from fighting inflation to concerns around cyclical growth and employment. The question the market is currently grappling with is how many cuts will result from this change of direction, but I argue that the implications are far broader than that. Central banks are easing even though core inflation in most countries remains well above their respective targets; all the while unemployment rates are still near historic lows. This apparent reluctance to administer the medicine needed to bring inflation back to target makes me more confident that the global economy is in the early stages of a long-term upward trend in inflation. I see several structural reasons for this rise, but a key explanation is that the monetary policy regime that has been in place since the mid-1990s is unravelling.
Central banks are, in effect, trapped. And it is a trap of their own making. In their fight to eliminate the risk of deflation, central banks effectively became fiscal entities. Purchasing government bonds and, in some notable instances, moving into negative interest rates are fiscal, rather than monetary policy decisions which have huge social implications. These decisions by unelected officials deepened the wealth gap as asset prices surged while real growth and productivity remained stagnant. On top of that, central banks — having successfully facilitated the response to the COVID pandemic — were slow to recognise the associated rise in the cost of living and its disproportionate impact on lower-income households. When they finally acted, it was primarily through higher interest rates rather than the sale of the assets they had accumulated, creating the perception that central banks had elected to hit the average person on the street rather than the select few that had gained the most. Today, we are witnessing the political fallout of these actions across much of the developed world.
Central banks will argue that they had no choice, with the alternative being far worse. There is a lot of truth in that, but it misses the point that unelected institutions cannot step over the fiscal threshold without consequences. It changes perceptions. From now on, governments will want to be involved in central bank policy more closely as they are wary of unelected officials straying too far into fiscal territory.
Given this politically fraught background, I suspect there are few central banks that are brave enough to spell out that keeping wages and inflation down will necessitate higher unemployment. The political backlash would be significant, particularly in an election year. The implication is that central banks will be very sensitive to the first signs of rising unemployment, even if, as our work suggests, the unemployment rate required to stabilise wage growth has moved up.
When a central bank stops viewing the world as a set of probabilities and instead makes choices on competing “costs”, it stops being truly independent. We are seeing an implicit politicisation of monetary policy: this happened a long time ago in Japan and is now occurring in other countries, albeit more subtly, as central banks’ remits have broadened. As an example, their ranks have been filled with ex-Treasury officials. Moreover, there is natural logic for central banks to tread the path of least resistance to try to avoid further political scrutiny.
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