AS THEY UNWIND QE, CENTRAL BANKS MUST COME CLEAN ABOUT INFLATION / THE FINANCIAL TIMES COMMENT & ANALYSIS

As they unwind QE, central banks must come clean about inflation

Credibility does not come from trying to achieve contradictory goals with one tool

by Alan Beattie




The US Federal Reserve this week did what central banks like doing best: the expected. In one of the most elaborately pre-signalled moves in recent history, the US central bank announced it would start to scale back quantitative easing, the programme of direct purchases of financial assets it adopted during the global financial crisis.

With the European Central Bank now actively talking about moderating its own QE programme, and one Bank of England policymaker musing about similar, the long-forecast “great unwinding” of the crisis-related radical monetary policy measures is finally under way. But what remains peculiar is that those same central banks seem intent on denying the extent to which the normal has changed, even if the extraordinary has dissipated.

More noteworthy this week than the removal of QE was the Fed simultaneously revising down its forecast for inflation and reiterating its intention to raise interest rates later in the year. Last week the BoE’s Monetary Policy Committee said it too expected to raise the cost of borrowing in the coming months. This despite persistent and inexplicably low inflation in the US and weakness in the UK economy, where domestically-generated price rises remain small.

The US and UK central banks both claim to be making decisions driven by the data. But rather than exercising judicial impartiality in the case for tighter policy, they seem to be acting more like trial lawyers, weaving together whatever strands of evidence they can find to fashion a case for a rise.

The world did not just suffer an extraordinary temporary shock in the form of the crisis that began in 2008. Economies around the globe also appear to have shifted to a new and unwelcome state of lower trend growth and lower equilibrium long-term interest rates — a development that probably predated the crisis.

Yet the Fed has tightened policy and the BoE is now prefiguring a rise. Neither can point at serious signs of inflationary pressure in either prices or wages. Both are working on the idea that traditional relationships between inflation and measures such as growth and employment are still sufficiently predictable to base monetary policy on them.

In the Fed’s case, it has already raised interest four times since December 2015, a cumulative increase of a percentage point, with two rises already this year. It is clearly signalling another increase in December. This is beginning to look rather like the Fed has returned to its traditional cyclical mode of a long series of interest rate changes in one direction, rather than each move being as likely down as up.

This will only be worsened if, as rumoured, the former Fed governor Kevin Warsh replaces Janet Yellen when her term as Fed chair comes up next year. Mr Warsh, who served at the Fed between 2006-2011, was a notorious worrywart about the possibility of inflation re-emerging, a threat that spectacularly failed to materialise.

As for the BoE’s warnings about rate rises in the near future, it has been here several times before and looked somewhat foolish each time. In 2013 the MPC gave unusually precise “forward guidance” that it would not raise interest rates until the unemployment rate had dropped below 7 per cent, a pledge it scrapped six months later as too inflexible. In 2014 Mark Carney, the bank’s governor, said a rise in the bank rate could come “sooner than markets currently expect”; in 2015 he said the decision on raising rates would “likely come into sharper relief” at the end of the year. Nonetheless, rates remained resolutely on hold before the Brexit-related cut in 2016.

As a Labour MP sardonically put it in 2014, the BoE has acted like an “unreliable boyfriend”. Its new idea of remedying this situation seems to be committing itself to getting married, or at least cohabiting, even though the relationship is manifestly not ready for it.

To be fair, there is one decent argument for higher rates, and that is to restrain credit growth. But that runs at a tangent to central banks’ inflation-targeting mandate. Short-term interest rates are a very blunt instrument with which to go after excessive credit growth or asset price bubbles.

If central banks have decided to focus on an outcome other than inflation, they should say so. If this means admitting that their macroprudential tools for control of credit and growth essentially do not work, so be it. Credibility and transparency do not come from clandestinely trying to achieve contradictory goals with one tool.

By being prepared to embrace the radical in the face of ill-informed criticism from politicians, investors and commentators — and from dissent in their own ranks — central banks have achieved extraordinary things since the global financial crisis. It would be most peculiar if now, when the pressure on them has abated, they mistakenly returned to a model of monetary policy rooted in the pre-crisis era.