The misguided attempts by some central banks to reduce inflation by raising interest rates and generating unemployment seem to be about credibility. Their reputations as anti-inflation fighters must be preserved despite the heavy cost. Even when the Nobel laureate and prominent monetarist Franco Modigliani renounced this theory in 2000, central banks continued to follow the creed he abandoned. More pain is being inflicted on the public through rate rises while the evidence stacks up that this is unnecessary suffering.
Last October, the Peterson Institute for International Economics produced a paper looking at 11 advanced economies and said the “little noticed dark side” of low inflation before the Covid pandemic was that “unemployment was almost continuously higher than needed to keep inflation low. Unless central bankers change their economic models, the world is likely to return to chronically excessive unemployment in the years after the [current] inflation surge.” The problem is that central bankers see economies running hotter than they actually are – and hike borrowing costs when there is no reason to do so.
The institute says that even when booms occurred – the biggest were in Spain and Italy – “there was no increase in … inflation”. It goes on to recommend that if inflation does not return quickly to their 2% target, “central banks should not … risk recessions in order to return to 2%”. Instead, the authors say, inflation targets ought to be relaxed. This heresy is very good advice. Unfortunately, many central bankers are too stuck in their destructive ways to accept it.
The Bank of England raised interest rates for the ninth time in a row last month. While inflation hurts the poorest most, it is predicted to be temporary. There is a danger of long-term damage to the economy by overtightening. Last September, the Office for National Statistics looked at measuring unemployment accurately. When it considered a more natural understanding of what it means to be unemployed, it calculated a UK jobless rate of about 7% – almost double the official count. High unemployment is such a waste of resources that no one interested in efficiency can be complacent about it. When he recanted, Modigliani admitted that “unemployment is due to lack of aggregate demand. This is mainly the outcome of erroneous macroeconomic policies.” What are the right ones? Jens van ‘t Klooster at Amsterdam University thinks high interest rates are about ending the “failed experiment” of quantitative easing rather than fighting inflation. But that seems like jumping out of the frying pan into the fire.
The economist Bill Mitchell, at Kyoto University, suggests we ought to be watching the Bank of Japan. In December, the Japanese central bank’s decision to allow its 10-year government debt yield to fluctuate half a percentage point both above and below its 0% target – twice as much as before – had free marketers predicting “a period of tightening”. But as Prof Mitchell correctly observed, it was a move to restore the capacity of Japanese firms to issue corporate bonds at reasonable rates. The Bank of Japan believes that the current bout of inflation is transitory and does not want to risk damaging economic growth, and record prime-age employment levels, by hiking rates. Seeking the right exchange rate and level of nominal growth to avoid a downturn, its policy is out of step for all the right reasons. This, as Prof Mitchell points out, makes for a very different country indeed.