Central Banks Wrongly Think They Have Power Over Inflation

Wednesday, June 29, 2022 6:00 a.m.


Paul Ormerod

Paul Ormerod is an economist at Volterra Partners LLP and an author.

LONDON, ENGLAND – MAY 05: Andrew Bailey, Governor of the Bank of England, leaves after addressing the media on the Monetary Policy Report at the Bank of England on May 5, 2022 in London, England. The Bank of England has raised interest rates to their highest level in 13 years in a bid to tackle the UK’s cost of living crisis. (Photo by Frank Augstein – WPA Pool/Getty Images)

The failures of central banks around the world to anticipate and control the current surge in inflation are now plain to all.

What’s going on with the highly technical models that economists at these institutions build to try to explain inflation?

If we look under the hood, we find a debate almost theological in its nature. Is there a concept called a Phillips curve? And, if so, how do you recognize it in real life?

In the 1950s, Bill Phillips, professor of economics at the LSE, claimed to have discovered a strong empirical relationship over the previous century between unemployment in the UK and rising money wages. The higher the unemployment, the lower the wage increases, and vice versa.

This was quickly extended by economists such as American Nobel laureates Paul Samuelson and Robert Solow to a link between unemployment and inflation.

Despite theoretical criticisms from other economists, including Milton Friedman, the Phillips curve has become deeply entrenched in central bankers’ thinking about inflation.

Here’s the problem: over the years, it has become increasingly difficult to find the relationship in the data. Throughout the West, we experienced a prolonged period from the mid-1990s when inflation and unemployment were low. For a while, both fall at the same time, completely contradicting the Phillips curve prediction.

Jerome Powell, Chairman of the Federal Reserve, went so far as to say in 2019 that “the relationship between the economic downturn and inflation has gotten weaker and weaker and weaker to the point that it’s a weak heartbeat that you can hear now”.

But, miraculously, it continued to exist. Jim Bullard, one of Powell’s colleagues who set US monetary policy, explained that “it was the Federal Reserve that killed the Phillips curve”. The fact that the Federal Reserve had successfully focused on inflation targeting over the past 20 years meant that inflation had become both much lower and more stable. The link between inflation and unemployment had been broken.

Ben Broadbent, Deputy Governor for Monetary Policy at the Bank of England, made the exact same claim in March 2020. The Phillips curve was still there, but its functioning had been suspended by central banks’ success in maintaining the low inflation thanks to their monetary policies. .

Given the way inflation has taken off, this argument pushes credibility beyond its limits.

The fact is that the Phillips curve has had a shaky empirical foundation almost since its discovery. For the past two decades it was not a curve but a flat line. At other times it has been L-shaped. It moves all the time.

Inflation in the West has been low in most countries for most of the past 150 years. There were occasional surges: Germany in the 1920s, some but not all countries in the 1970s.

More than forty years ago, Cambridge economist Bob Rowthorn argued that high inflation occurs whenever there is a lack of consensus on the distribution of income, especially between profits and wages. . A wage-price spiral would develop rapidly, which could only be broken by a sharp rise in unemployment.

Rowthorn’s view, in the current environment, is worrying and suggests that inflation will persist for some time to come.

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