Central Bank Independence Faces Biggest Test By Inflation

The recent resurgence in inflation is testing Central Banks internationally.

Central Bank Independence Faces Biggest Test By Inflation

The recent resurgence in inflation has been putting central banks to the test, with the US reporting an annual rate of 6.8 percent, which is the highest in nearly 40 years. The concern they all have is whether this price rise is transitory (transitory) or long-term.

If the problem is only temporary, treating it aggressively would be counter-productive. It will needlessly delay the recovery if central banks tighten monetary policy excessively by rapidly raising short-term interest rates or quickly unwinding government asset purchases (known as quantitative easing or QE) which supported many economies during the COVID economic shock.

All of the public comments by central bankers imply that tough choices will have to be made. The chair of the US Federal Reserve, Jay Powell, said recently that the flourishing US economy and rising inflation meant the Fed would scale back its QE asset purchases more quickly (they are now scheduled to end in June 2022).

The Bank of England's asset purchases, which are set to come to an end this month, "the conditions now existed for him to vote for higher interest rates," according to Huw Pill, the bank's chief economist. Despite strong inflation, which is currently over 2%, the head of the European Central Bank (ECB) passed a more dovish tone, stating that it is unlikely the ECB will raise interest rates in 2022 due to transitory inflation.

What is the significance of the current inflationary crisis, and what are its origins?

Inflation causes

The recent spike in prices is not as significant as that from the 1970s and early 1980s, when oil prices sharply increased.

However, if the current rate of inflation is compared to that seen in the early 2000s, it is one of the most significant shocks since the Bank of England became independent and the ECB was established.

The current inflation is due largely to the pandemic's disruption of important global supply chains. In industries like electronics and automobiles, bottlenecks and shortages of critical inputs such as semiconductors arose as consumer demand recovered more swiftly than suppliers could satisfy it. Similarly, shipping container shortages and freight capacity constraints have increased costs.

The quick economic expansion in 2021 has also put a strain on energy costs, particularly spot gas prices in Europe. Meanwhile, there have been labor shortages to deal with: the UK and the United States are among those countries that appear to be seeing labor force participation decline as people retire. The UK and certain northern European countries, in particular, have not seen enough short-term migrants for sectors such as hospitality and logistics. Employers must pay higher salaries to fill vacancies when there are too few workers available.

Inflation expectations

What is the best way to respond to inflation? The biggest problem for central banks is consumer and business expectations regarding price increases. If people and firms are confident that prices will continue to increase at a similar rate, as they did in the 1970s, they will seek to incorporate it into their wage demands and future pricing. Inflation will then become more permanent.

What is the evidence for these second-round effects on wages and price setting? There's some evidence from consumer surveys and bond prices that inflation expectations in the United States, European Union, and United Kingdom have risen somewhat in the last half of 2021, but they appear to be restrained.

Another distinction between the 1970s and 1980s is that labour markets are more flexible, in the sense that private-sector trade unions have less wage bargaining power, and as a result of globalization there is greater international competition. Rising prices may thus be absorbed by real-wage declines rather than triggering a wage-price spiral (that is, they would rise below the rate of inflation).

It all depends on whether the COVID supply disruptions are only transitory, because eventually, as labour markets across most nations tighten, employers will be forced to pay salaries that keep up with inflation. Unfortunately, the omicron variant is a symptom that when COVID becomes widespread, economic growth may be interrupted by brief shortages and additional supply shocks, possibly putting pressure on businesses to offer greater salaries.

Central banks and independence

The key to determining if inflation is transitory will be future labour market and expectations data. Central banks may only need to gradually raise rates in this case, assuming that by early to mid-2022, inflation appears to be dissipating.

However, if data indicate that inflation is continuing to rise above central banks' inflation targets (for example, 4% to 5%), it would suggest that a wage-price spiral has begun.The Federal Reserve would then have no choice but to increase short-term interest rates and decrease QE - potentially slowing economic activity until wage and price growth subsided. This can result in a severe recession, which is known from the 1970s and early 1980s.

At any rate, QE must be discontinued gradually. It has generated more demand for government bonds and expanded the supply of money available to invest in other assets such as stocks, so tapering is likely to cause upheaval in these markets. This may be exacerbated by investors selling their stocks in anticipation of tighter monetary policy resulting from slower economic growth.

The QE purchases have also substantially increased the balance sheets of central banks. Since the start of the pandemic, for example, the Fed's balance sheet has expanded from about USD 4 trillion to around USD 8.7 trillion. This debt must also be unwound gradually. It can either be done gradually as QE debt matures or – if central banks decide to tighten monetary policy more quickly – by selling these bonds on the market.  This may entail selling at a loss, which implies that governments would have to replenish balance sheets of central banks. It may put the independence of central banks at risk by making them reliant on government in this manner.

There's also a more immediate danger to central bank independence, which was granted several decades ago to prevent monetary policy from being influenced by politics and to assuage investors' fears that inflation would be kept in check.During a severe economic crisis, the decision-making process at a central bank may be influenced by external factors. Central bankers may be subject to political and media pressure, either to move too fast in combating inflation or too slowly in supporting the economy's recovery.

Despite the warnings from Huw Pill, some central banks, such as the Bank of England, are expected to wait for another year before raising interest rates – owing to the uncertainties surrounding omicron variant. The ECB is also keeping a tight grip on things. So all eyes will be focused on the Fed to see if it tapers its quantitative easing program more quickly than previously anticipated.  In the meantime, it may be better to wait. The next few weeks will bring us further information on both inflation expectations and how COVID may influence our economies.

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