Why did central banks get inflation so wrong?

Today is the twenty fifth anniversary of “Independence Day”: the day the Bank of England was granted operational independence by the Treasury to meet the inflation target set by the Government. It was introduced by the new Chancellor of the Exchequer, Gordon Brown, just four days after the 1997 election victory to demonstrate that the New Labour Government was determined to avoid inflation such as Britain had experienced under Labour in the 1970s.

For most of these 25 years, the Bank has been remarkably successful in holding inflation to an average of 2%. However, as early as the summer of 2020 the spectre of inflation could be seen on the horizon. Since early 2021, measured inflation has been rising steadily. It is now 7% and expected to reach over 8%, while the retail price index is predicted to rise into double figures. For most of this period the Bank has argued that the increase would be “transitory”. Other central banks have fared no better. Even though the prime responsibility of the Bank of England, the US Federal Reserve and the European Central Bank has been to control inflation, all have missed their target.

So why did they get it so wrong?

One possibility might be the poor quality of their staff. In terms of intellectual ability, the economics staff of central banks tend to be first-rate and produce endless papers of interesting and relevant research. Similarly, their governors and deputy governors are devoted public servants, genuinely committed to the good of society. The calibre of those who run central banks, therefore, is not a credible reason for their failure.

A second possibility is the unprecedented nature of the circumstances facing them. Andrew Bailey took up his position as Governor in mid-March 2020, only to find one week later that the Government had locked down the UK economy as a response to Covid. The Bank was soon facing forecasts of not just the worst fall in output since the Great Depression of the 1930s, but the largest peacetime economic and fiscal shock in 300 years. Added to the difficulty was the Great Resignation, with over a million workers exiting from the labour force, partly because of those returning home from Brexit, those retiring and younger workers seeking a career break. According to the Office for National Statistics, it has affected all sectors of the economy.

The Bank rate was slashed to 0.1%, banks provided generous credit to companies backed by government guarantees, the furlough scheme was introduced, enabling workers to be paid to work from home and through Quantitative Easing the Bank enabled the Treasury to pay for it. Most economists thought these measures were the appropriate policy response.

Although Covid was unique, central banks have in the past faced other extraordinary challenges: the 2008 financial crisis, which nearly resulted in the collapse of the global banking system, and the Euro crisis of 2012-13, which almost led to the collapse of the Euro.

A third possible explanation, put forward by the ex-governor of the Swiss National Bank, is that the old inflation playbook no longer applies. Just think of inflation as the noise from the economic engine. In the past it resulted from the engine revving too fast. Now, however, it constantly misfires due to capacity constraints. These have been evident from initial lockdowns and certainly more marked since the Russian invasion of Ukraine. But they in no way invalidate empirical evidence that it was excess demand which led to the take-off of inflation, the overhang of which is still with us.

I believe that the heart of the problem of why central banks have got this inflation wrong is the flawed intellectual framework in which policy has been conducted. This can be broken down into five major parts.

First there is in modern economics, at least over the past half century, a major emphasis on quantitative analysis, mathematical economics, econometrics, model building and forecasting. The Bank of England has built very sophisticated models — usually referred to as DGSE models (dynamic, general equilibrium, stochastic, equilibrium) — which it uses as the basis of its quarterly forecasts of the rate of inflation. An older version of the model broke down during the 2008 financial crisis and a new one was constructed. Sophisticated model building has a place and I recognise its value.

One feature of these New Keynesian models is that they incorporate expectations of the future behaviour of economic agents in the monetary transmission system as important to their predictions. In particular, they assume that the structure of the economy is relatively stable. They can handle “known unknowns” by applying standard economic randomness or risk. What, however, they cannot handle are the “unknown unknowns” or “radical uncertainty” — something that Frank Knight, one of the founders of the Chicago School of Economics in the 1940s, placed centre-stage in his framework for economic thinking. It has been singled out and adapted for today’s economy by John Kay and Mervyn King in their book Radical Uncertainty.

To recognise that the world is a place of uncertainty, which is radically different from risk, means that while risk is susceptible of measurement, which can then be inserted as a specific number in a model, uncertainty is a wholly different creature. The constant shifts within the world we have inhabited for the last two to three years with Covid and its many mutations, lockdowns, disruptions to supply chains, trade barriers, the Russian invasion of Ukraine and other political realignments are classic examples of radical uncertainty, not risk. To capture this fast-moving scene is increasingly difficult for econometric models, however sophisticated.

Second, despite the sophistication of the Bank’s forecasting models, it has no explanation of how inflation is determined in the medium term (three years or more). In the short term, say 6 to 9 months, forecasts can rely on prices or rates in future markets (e.g. oil), announced expectations by companies of price rises or cost savings, likely wage settlements and so on. In the medium term, precious little evidence exists.

Mervyn (now Lord) King, when Governor of the Bank of England, chaired 184 meetings of the Monetary Policy Committee (MPC). In a recent outstanding lecture on the deficiencies of current monetary policy, he said this:

“In the early days of the MPC we pored over various forecasts for inflation produced by the Bank staff for different interest rate decisions. No matter which interest rate path we simulated, inflation always returned to target. Why? Because in these models the only determinant of inflation in the medium term was the official target”.

The logic behind this was that the major determinant of future inflation was the expectations which people have of inflation. Expectations drive future inflation and expectations are formed by the “forward guidance” given to the markets by the Bank. But what if the Bank gets its forward guidance wrong? The fact is it doesn’t matter. The reason is that as it begins to see what the medium term looks like, the Bank can always change interest rates or vary Quantitative Easing to change the inflation outcome so as to meet the official target.

A third reason of why central banks have got inflation wrong is the neglect of the money supply and the role it plays. This is surprising, because in the history of British economic thought inflation has been associated with “too much money chasing too few goods”. This was true of classical economists (Smith, Hume, Ricardo) as well as neo-classical economists (Marshall, Mill, Edgeworth, Bigon). In 1923 Keynes wrote: “This theory is fundamental. Its correspondence to fact is not open to question. Nevertheless it is often misstated and misrepresented. Goshen’s saying of sixty years ago that ‘there are many people who cannot bear the relation of the level of prices to the volume of currency affirmed without a feeling akin to irritation’ still holds good.”

And it still holds good today.

The theory can easily be misstated in too simplistic and mechanistic a form, failing to recognise shifts in the public’s need for liquidity, supply side shortages, the variability of time lags and capacity constraints. In 2020 the growth of broad money increased from 4.4% (January) to 14.2% (December) — the peak was 15.4% in February 2021 — and has been followed with a lag of 18-24 months in inflation. M4 money (a measure of the amount of money circulating in the economy outside banks) bottomed in May 2019 and CPI inflation bottomed in February 2021, a shift of 21 months. I still find it extraordinary, reading the accounts of MPC meetings, that the money supply is hardly mentioned, which raises questions over the diversity of MPC members, as well as group-think among officials of the Bank of England, the US Federal Reserve and the European Central Bank.

Fourth is the role placed in the past on “forward guidance” regarding the future course of the economy, monetary policy and interest rates. By providing this information, the Bank clearly thought it was providing a service to financial markets.

However, during Mark Carney’s time as Governor, far from simplifying the markets’ understanding of what the Bank was trying to do, he notoriously acquired the title of “the unreliable boyfriend”. If any evidence were needed of the arcane nature of forward guidance, Ben Broadbent’s speech of 30 March 2022 — which sets out “Delphic” guidance in contrast to “Odyssean” guidance — wins game, set and match.

The latest example of the misleading nature of the Bank’s forward guidance came last November, when the markets assumed that interest rates would be raised. The Governor did not promise such a rise, but that was the market’s interpretation. When rates were raised in December the markets were then even more surprised.

The Bank has a clear responsibility to explain its view of how the economy works, but given the radical uncertainty of the world in which we live, it is in no position to start giving any sort of guidance regarding interest rates and inflation. Financial markets are perfectly capable of forming their own expectations from the raw data available to them and using common sense to decide what is happening, without the Bank adding additional layers of complexity. It was therefore encouraging to hear the Governor say recently that the Bank may abandon forward guidance. All power to him.

The fifth reason the Bank of England has lost control of inflation is simply the increasing and conflicting number of objectives it is seeking to meet.

The primary objective of the Bank of England is to maintain low and stable prices. But it also has responsibility for the stability of the UK financial system, support for the objectives of government economic policy (including specifically growth and employment), the soundness of firms, as well as facilitating competition between financial institutions, and most recently addressing climate change risks which affect the financial system.

Because of its many objectives the Bank is required to pursue each of them. The danger is that if it does prioritise bringing inflation under control, it will be criticised by businesses for creating recession. It is a no-win situation for the Bank. To pursue multiple objectives will force it to respond to public opinion. However, this is really the task of politicians, not unelected central bankers. If the Bank clearly focused on making a priority of reducing inflation, this would change people’s expectation of future inflation and so reduce the rise in unemployment. The one unambiguous conclusion from different countries’ experience of reducing inflation is that there is no gain without pain.

In my view, however, although the failure to predict inflation has been a wake-up call for the Bank of England, this failure should certainly not undermine its independence from government. To give government a greater role in fixing interest rates and any future QE would only lead to more explicit politicisation of monetary policy, which would be a step backwards. Two wrongs do not make a right.

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