Every investor wants to know whether central banks are prepared to cause a recession in order to force inflation down. Surely, officials are bluffing, right? But think about it from the central banker’s perspective. Yes, a recession would be bad: people would lose their jobs, and it could take a while to recover. But recessions happen all the time and they rarely ruin any central banker’s reputation. Some, such as Paul Volcker, are even celebrated for their “toughness” in the face of economic pain. And if a recession happens now, the authorities can blame Putin or say it was the only way to tame the inflation monster (they love a good counterfactual). Runaway inflation, on the other hand, would leave a darker legacy. Jerome Powell, Christine Lagarde and others would be joining Arthur Burns on university syllabuses for the semester on “historical monetary failures”. In 40 years’ time, economists would still be discussing how they “let IT (the 1970s) happen again”. No central banker wants to become a case-study in how to fail.
A recent report from the BIS outlines the nightmare scenario for central banks. For a long time, BIS analysis has not been useful for analysing monetary policy. The Basel-based “central bankers’ central bank” was obsessed with publishing endless critiques of ZIRP, QE and other “unconventional stimulus”, a message that clearly did not resonate with the view at the top of the Fed, the ECB or the majority of officials who were actively involved in policy decisions. But the BIS’s latest report on the danger of a “new paradigm” in global inflation clearly strikes at central bankers’ worst fears. It explains, clearly and with lots of fabulous charts, why the authorities are suddenly more hawkish than anyone could have imagined 12 months ago – why Jerome Powell is suddenly celebrating Paul Volckers’ legacy, and why the ECB and even the BoE now have a rather bizarre obsession with the monetary traditions and “credibility” of the Bundesbank.
The BIS analysis is largely statistical. It argues that there are two basic inflation regimes – “low” and “high”, each of which has its own self-reinforcing properties, although economies occasionally transition from one to the other. In the low-inflation regime, “relative” or sector-specific price changes are the dominant driver of the CPI. These tend to have a transitory effect, as they die out quickly. This is not a regime in which wage- or price-setters need to pay a great deal of attention to the overall inflation rate. Aggregate price pressures are subdued, and everyone takes this for granted. In the “high-inflation regime”, on the other hand, broader CPI developments start to have a much more discernible impact, with inflation itself becoming the focal point for private-sector decisions. This shift in emphasis leads, in turn, to behavioural changes that will cause inflation to become entrenched. In the high-inflation regime, even relative price shifts – such as spikes in energy prices – have persistent effects. And you know transitioning from a low inflation regime to a high inflation regime is under way based on the behaviour of prices within the CPI. Once they become more correlated, as they have over the past 12 months, there is a good chance – according to the BIS – that the economy is transitioning.
Rather ominously for financial markets, the BIS concludes: “Central banks fully understand that the long-term benefits [of safeguarding price stability] far outweigh any short-term costs – credibility is too precious an asset to be put at risk.” This suggests that a policy pivot is far away…