8/27/22, 11:11 PM Stop berating central banks and let them tackle inflation | Financial Times

Opinion  Central banks

Stop berating central banks and let them tackle inflation
Despite their slow reaction, now is not the time for a radical redesign of their mandates

RAGHURAM RAJAN

© Ann Kiernan

Raghuram Rajan YESTERDAY

The writer is a former central banker and a professor of finance at the University of
Chicago’s Booth School of Business

As central bankers meet in Jackson Hole, they must wonder how far they have fallen
in the public’s eyes. A short while ago, they were heroes, supporting feeble growth
with unconventional monetary policies, promoting the hiring of minorities by
allowing the labour market to run a little hot, and even trying to hold back climate
change, all the while berating paralysed legislatures to do more. Now they stand
accused of flubbing their most important task, keeping inflation low and stable.
Politicians, sniffing blood and mistrustful of the power of unelected officials, want to
re-examine central bank mandates.

Hindsight is, of course, 20/20. The pandemic was unprecedented, and its
consequences for the globalised economy very hard to predict. The fiscal response,
perhaps more generous because polarised legislatures could not agree on whom to
exclude, was not easy to forecast. Few thought Vladimir Putin would go to war, and
send energy and food prices skyrocketing.
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Yet undoubtedly, central bankers were slow to react to growing signs of inflation. In
part, they believed they were still in the post-2008 financial crisis regime, when every
price spike, even of oil, barely affected the overall price level. In an attempt to boost
excessively low inflation, the Fed even changed its framework during the pandemic,
announcing it would be less reactive to anticipated inflation and would keep policies
more accommodative for longer. This was the right framework for an era of
structurally low demand and weak inflation, but exactly the wrong one to espouse just
as inflation was about to take off and every price increase fuelled another. But who
knew the times were a-changing?

Even with perfect foresight — and in reality they are no better informed than capable
market players — central bankers may still have been behind the curve. This is
understandable. A central bank cools inflation by slowing economic growth. No
matter how independent it is, its policies have to be seen as reasonable, or else it loses
its independence.

With governments having spent trillions to support their economies, employment just
recovered from terrible lows and inflation barely noticeable for over a decade, only a
foolhardy central banker would have raised rates to disrupt growth if the public did
not yet see inflation as a danger. Put differently, pre-emptive rate rises that slowed
growth would have lacked public legitimacy — especially if they were successful and
inflation did not rise subsequently. Central banks needed the public to see higher
inflation to be able to take strong measures against it.

So what happens now? The Fed’s determined policies are having some effect on
economic activity. But it is a matter of guesswork how high policy rates will have to go,
and how long they must stay high to cool the hot labour market. The task of the
European Central Bank and Bank of England is harder because they will be tightening
into recessions and energy prices account for more of the inflationary surge than in
the US. They have to gauge how much tightening will contain inflationary
expectations without exacerbating the supply constraint-induced downturn.

Central bankers know the battle against high inflation well and have the tools to
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combat it. They should be free to do their job. This is not a time for postmortems to
assess central bank functioning. Spending to alleviate the pain of high inflation and
slowing growth can help, but governments should direct this only towards the most
needy so that it does not spur more inflation.

Of course, when central banks succeed in bringing inflation down, we will probably
return to a low-growth world. It is hard to see what would offset the headwinds of
ageing populations, a slowing China and a suspicious, militarising, deglobalising
world. That low-inflation, low-growth world is one central bankers understand less
well. The tools central bankers used after the financial crisis, such as quantitative
easing, were not particularly effective in enhancing growth. Furthermore, aggressive
central bank actions could precipitate more financial sector instability.

When all settles back down, what should central bank mandates look like? In matters
such as combating climate change or promoting inclusive employment, the policies of
central banks have only indirect impact. Truly, these are tasks for governments.
Central banks should not use the excuse of government paralysis to step into the
breach.

Clearly, they should re-emphasise their mandate to combat high inflation. What if
inflation is too low? Perhaps like the virus, we should learn to live with it. Arguably, so
long as low inflation does not collapse into a deflationary spiral, central banks should
not fret excessively about it. Decades of low inflation in Japan have not exacerbated
its problems, which are more directly attributable to population ageing and a
shrinking labour force.

Central banks may also need a stronger mandate to maintain financial stability — for
an extended period of low inflation fuels higher asset prices, and consequently
leverage. Will these twin mandates condemn the world to low growth? No, but they
will place the onus for fostering growth back on the private sector and governments,
where they belong. More focused and less interventionist central banks would
probably deliver better outcomes than the high-inflation, high-leverage, low-growth
world we now find ourselves in.

Are we heading towards a global recession? Our economics editor Chris Giles and
US economics editor Colby Smith discussed this and how different countries are
likely to react in our latest IG Live. Watch it here.

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