Warwick Lightfoot is an economist, and a former Special Adviser to three Chancellors of the Exchequer.
“Counter-inflation and monetary policy are in shambles.” These were 5he words of Walter Eltis the Director-General of the National Economic Development Council to me, the day I went to work at the Treasury in 1989. Much the same could be said today.
The present inflation is the result of the conduct of the world’s principal central banks; few institutions, and certainly no other economic institution, have accumulated as much authority, autonomy, and power as have modern central banks over the last thirty years.
While in some instances Congress in the US and the Treasury in the UK give them their policy objective or mandate, they are pretty much left to get on with achieving it, on their own.
After the establishment of the Bank of England’s Monetary Policy Committee, its members, when asked how they would hit their inflation target, often explained that they enjoyed constrained discretion. This meant they had an inflation target, but could set about meeting it in any way they wanted.
The Federal Reserve Board in the US effectively acts as a central bank to the world, as we saw in the great financial and economic crisis between 2007 and 2009 and during Covid. Since the mid-1990s it has also dominated the thinking and intellectual approach to monetary policy of central bankers in general.
There are a range of monetary instruments available to a central bank. They include minimum reserve requirements, monetary supply targets, and foreign exchange and interest rate targets. Each has merits and demerits.
Having made extensive (and in terms of getting inflation down, successful) use of both monetary and foreign exchange targets, for a variety of technical reasons central banks increasingly decided to focus on their ultimate objective, inflation – without any intermediate targets that may throw up awkward or embarrassing warning signals.
From the mid-1990s economists at the Federal Reserve increasingly framed meeting their goal of price stability with employment, in terms of an academically-fashionable and Keynesian Dynamic Stochastic General Equilibrium model. This focused on setting monetary conditions in terms of a realistic estimate of the economy’s trend rate of growth (growth without inflation), and where the rate of economic activity is in relation to trend, estimating the so-called output gap.
This approach has been replicated across the OECD. The approach of the Bank of England, in relation to the Federal Reserve, could be institutionally described as big brother/little brother.
However, it was intellectually flawed: the models do not have a monetary sector, have a tendency to revert of trend no matter what the shock, and offer little forward guidance on the future path of inflation (as the Bank of England published paths for inflation illustrate).
Moreover, in the context of a medium-sized open economy such as that of the UK, an output-gap approach offers little guidance about inflation, given the importance of trade, whereas the exchange rate and pass through of international prices is significant.
In many respects the Bank of England has been a clumsy operator. For years it continued to use the Discount Houses to manage money markets. In the 2000s it suggested there was no connection between house prices and inflation. When the credit and banking crisis came in 2007, it was slower and less effective in responding than either the ECB and Federal Reserve.
And in the face of the present inflation, it has been timid about raising rates.
The intellectual approach by the Federal Reserve has been amplified by central bankers allowing themselves to be distracted by recondite academic debates on difficult social issues which are remote from their principal function. These are matters (economic inequality, structural discrimination against minority communities in the labour market and decarbonisation and climate change, et al) where they have neither the tools nor the political legitimacy to be effective.
Academic economists have encouraged this distraction, not least by promoting a debate about the benefits of abandoning two per cent inflation targets and targeting a rate of inflation more than twice that level. For years these distractions have been rehearsed at seminars and conferences such as the Jackson Hole Symposium on monetary policy, organised annually by the Federal Reserve Bank of Kansas.
Trying to use monetary policy as a stimulus when it had lost traction between 2010 and 2020, when the focus should have been on fiscal stimulus, led to monetary conditions becoming far too loose. Very low interest rates made it impossible for money, credit, and bond markets to price credit properly.
This contributed to serial asset price bubbles in debt, equity, and property markets. It also contributed to the phenomenon of the zombie firm, kept going when it no longer has a proper commercial or economic purpose by access to cheap borrowing.
This was compounded by the asymmetric approach taken by central banks to inflation and recession. They risk inflation above target in preference to a short or shallow technical recession. This vitiates the processes of creative destruction at the heart of capitalist accumulation, productivity, and growth.
When inflation started to take off in 2021, Janet Yellen, the present US Treasury Secretary, rightly said that central banks had the tools to counter it: increased interest rates. Yet they persuaded themselves the inflation was transitory and the result of relative price effects that would pass through.
Instead of decisive expedition, they took a Fabian approach. The role model has been the Roman general in the Punic war, who earned the title cunctator – literally ‘delayer’. Hesitant baby steps have been the order of the day.
Real interest rates remain negative. An effective disinflation is difficult to bring about without either positive real interest rates or a willingness to have a short-term loss of employment and output.
The episodes of successful disinflation in France, the UK, and US in the 1980s and 1990s involved both. Paul Volker, Jacques Delors, Pierre Bérégovoy, as well as both Margaret Thatcher and John Major and their chancellors – Sir Geoffrey Howe, Nigel Lawson and Norman Lamont – were unflinching. A clear policy priority and willpower is everything.
Neither finance ministers nor central bankers should mislead themselves or the public with the promise implied by talk of when interest rates come down. Both short-term interest rates and the overall structure of the yield curve need to remain closer to their historical level, both to contain future inflation and for the proper micro-economic functioning of credit markets.
The relationship between the Government and the Bank of England should be reviewed, along with the working of the inflation target, the role of the exchange rate in disinflation, and the intellectual approach that the central bank takes.
Warwick Lightfoot is an economist, and a former Special Adviser to three Chancellors of the Exchequer.
“Counter-inflation and monetary policy are in shambles.” These were 5he words of Walter Eltis the Director-General of the National Economic Development Council to me, the day I went to work at the Treasury in 1989. Much the same could be said today.
The present inflation is the result of the conduct of the world’s principal central banks; few institutions, and certainly no other economic institution, have accumulated as much authority, autonomy, and power as have modern central banks over the last thirty years.
While in some instances Congress in the US and the Treasury in the UK give them their policy objective or mandate, they are pretty much left to get on with achieving it, on their own.
After the establishment of the Bank of England’s Monetary Policy Committee, its members, when asked how they would hit their inflation target, often explained that they enjoyed constrained discretion. This meant they had an inflation target, but could set about meeting it in any way they wanted.
The Federal Reserve Board in the US effectively acts as a central bank to the world, as we saw in the great financial and economic crisis between 2007 and 2009 and during Covid. Since the mid-1990s it has also dominated the thinking and intellectual approach to monetary policy of central bankers in general.
There are a range of monetary instruments available to a central bank. They include minimum reserve requirements, monetary supply targets, and foreign exchange and interest rate targets. Each has merits and demerits.
Having made extensive (and in terms of getting inflation down, successful) use of both monetary and foreign exchange targets, for a variety of technical reasons central banks increasingly decided to focus on their ultimate objective, inflation – without any intermediate targets that may throw up awkward or embarrassing warning signals.
From the mid-1990s economists at the Federal Reserve increasingly framed meeting their goal of price stability with employment, in terms of an academically-fashionable and Keynesian Dynamic Stochastic General Equilibrium model. This focused on setting monetary conditions in terms of a realistic estimate of the economy’s trend rate of growth (growth without inflation), and where the rate of economic activity is in relation to trend, estimating the so-called output gap.
This approach has been replicated across the OECD. The approach of the Bank of England, in relation to the Federal Reserve, could be institutionally described as big brother/little brother.
However, it was intellectually flawed: the models do not have a monetary sector, have a tendency to revert of trend no matter what the shock, and offer little forward guidance on the future path of inflation (as the Bank of England published paths for inflation illustrate).
Moreover, in the context of a medium-sized open economy such as that of the UK, an output-gap approach offers little guidance about inflation, given the importance of trade, whereas the exchange rate and pass through of international prices is significant.
In many respects the Bank of England has been a clumsy operator. For years it continued to use the Discount Houses to manage money markets. In the 2000s it suggested there was no connection between house prices and inflation. When the credit and banking crisis came in 2007, it was slower and less effective in responding than either the ECB and Federal Reserve.
And in the face of the present inflation, it has been timid about raising rates.
The intellectual approach by the Federal Reserve has been amplified by central bankers allowing themselves to be distracted by recondite academic debates on difficult social issues which are remote from their principal function. These are matters (economic inequality, structural discrimination against minority communities in the labour market and decarbonisation and climate change, et al) where they have neither the tools nor the political legitimacy to be effective.
Academic economists have encouraged this distraction, not least by promoting a debate about the benefits of abandoning two per cent inflation targets and targeting a rate of inflation more than twice that level. For years these distractions have been rehearsed at seminars and conferences such as the Jackson Hole Symposium on monetary policy, organised annually by the Federal Reserve Bank of Kansas.
Trying to use monetary policy as a stimulus when it had lost traction between 2010 and 2020, when the focus should have been on fiscal stimulus, led to monetary conditions becoming far too loose. Very low interest rates made it impossible for money, credit, and bond markets to price credit properly.
This contributed to serial asset price bubbles in debt, equity, and property markets. It also contributed to the phenomenon of the zombie firm, kept going when it no longer has a proper commercial or economic purpose by access to cheap borrowing.
This was compounded by the asymmetric approach taken by central banks to inflation and recession. They risk inflation above target in preference to a short or shallow technical recession. This vitiates the processes of creative destruction at the heart of capitalist accumulation, productivity, and growth.
When inflation started to take off in 2021, Janet Yellen, the present US Treasury Secretary, rightly said that central banks had the tools to counter it: increased interest rates. Yet they persuaded themselves the inflation was transitory and the result of relative price effects that would pass through.
Instead of decisive expedition, they took a Fabian approach. The role model has been the Roman general in the Punic war, who earned the title cunctator – literally ‘delayer’. Hesitant baby steps have been the order of the day.
Real interest rates remain negative. An effective disinflation is difficult to bring about without either positive real interest rates or a willingness to have a short-term loss of employment and output.
The episodes of successful disinflation in France, the UK, and US in the 1980s and 1990s involved both. Paul Volker, Jacques Delors, Pierre Bérégovoy, as well as both Margaret Thatcher and John Major and their chancellors – Sir Geoffrey Howe, Nigel Lawson and Norman Lamont – were unflinching. A clear policy priority and willpower is everything.
Neither finance ministers nor central bankers should mislead themselves or the public with the promise implied by talk of when interest rates come down. Both short-term interest rates and the overall structure of the yield curve need to remain closer to their historical level, both to contain future inflation and for the proper micro-economic functioning of credit markets.
The relationship between the Government and the Bank of England should be reviewed, along with the working of the inflation target, the role of the exchange rate in disinflation, and the intellectual approach that the central bank takes.