While the eyes of the world are on Cop26, we are entering a moment of profound fragility for the world economy, as major central banks struggle to cope with the aftermath of the pandemic and ongoing supply disruptions. Far from being “temporary” or “transitional”, as central banks and high-spending governments have argued, the spike in prices over the past 18 months looks likely to continue for the foreseeable future. Talk is now turning to the imminent prospect of increases in interest rates across the major developed economies, with the Federal Reserve Board in the US and the Bank of England’s rate-setting Monetary Policy Committee both due to meet this week.
But to start pushing up interest rates now would be a serious policy error. The immediate impact of a small adjustment of the Bank of England’s base rate matters less than the clearest possible signal it would send that the central bankers have failed to come to terms with the high-price, high-risk, low-growth world we are now entering. A monetary policy framework developed almost 25 years ago is scarcely adequate to deal with today’s challenges of rising environmental constraints and sky-rocketing inequality.
There is an elementary problem with trying to drive up the cost of borrowing when confronted with inflation of the kind we now have. Prices have been rising over the past year and a half or so not because money has become too cheap, but because it has become harder and more expensive to produce goods and services.
The supply chain disruptions caused by Covid-19, and the lockdowns and restrictions it led to are one part of the picture, inhibiting the supply of manufactured goods across the world. These constraints on supply are ongoing, with disruptions to production still afflicting factories in China and Vietnam. Meanwhile, droughts in Canada, floods in Brazil and an earlier plague of locusts of “biblical proportions”, spreading from Yemen down through the east coast of Africa, have all contributed to a 30 per cent increase in the price of food in the past year. Semiconductor manufacturing, too, has been disrupted by a drought in Taiwan and winter storms in Texas, directly contributing to the global chip shortage.
Raising interest rates will do nothing about any of this. As even the Bank of England’s governor, Andrew Bailey, admitted in a recent speech, “monetary policy will not increase the supply of semi-conductor chips, it will not increase the amount of wind… and nor will it produce more HGV drivers”. He’s absolutely correct, but that also means there is no case for the interest rate rises the central bank is considering. If anything, interest rates should be held down to reduce the cost of investment, enabling companies to expand supply.
Yet all the chatter from around the Bank suggests rates rises are imminent. The expectation has been reinforced by the appointment of former Goldman Sachs banker Huw Pill as the Bank’s new chief economist, replacing the free-thinking Andrew Haldane.
Pill himself is an inflation hawk, who believes, as he told the Financial Times, that a central bank’s core focus should be “price stability” – overriding any other concern. In the same interview, he was unabashed in his praise for the man he calls his “mentor”, Otmar Issing. Issing cut his teeth as central banker at the Bundesbank in the early 1990s, where he helped drive unemployment in former East Germany to well above 15 per cent through a succession of merciless interest rate increases. Issing was later the primary architect of the euro, installing the near fatal bias towards tight money in its operation that helped tip southern Europe into its worst economic crisis since the Great Depression. In the Issing world, price stability takes precedence over real economic activity.
At precisely the point where we need a central bank sensitive to the wider fragilities of the economy – including those caused by environmental instability – we may have ended up with a central bank that is disastrously focused on one not especially useful target – comparable to, for example, the obsession of the Bank of England and the Treasury with returning to the gold standard in the 1920s. (When Britain rejoined the fixed exchange rate gold standard system in 1925, setting the value of the pound at a very high level, the result was a near-instant slump.)
At the moment, it’s unlikely that the Bank of England will do anything more than take the very smallest steps in rates rises. Bailey has also all but ruled out reigning in quantitative easing (QE) in the near future. But as economists Charles Goodhart and Manoj Pradhan argue in a short but compelling new analysis, small, tentative steps open up a further risk. Months or years of incorrect inflation forecasts and the central banks’ actions failing to hold inflation down could result in a “horrendously risky” shift in strategy as central banks attempt to recover their “credibility”. Central banks might feel compelled to hike interest rates to levels not seen in decades and immediately start winding down QE.
The consequence would be a collapse in asset prices, mass bankruptcies and a prolonged recession. But if central banks come to believe that their own credibility in the eyes of financial markets is at stake, Goodhart and Pradhan think this panicked reaction is a significant risk in future.
Ultimately, monetary policy is an inadequate set of instruments to deal with the future we face. We are heading into a world of real supply constraints. Under these circumstances, the best monetary policy is to largely get out of the way – although there is a case to be made that the Bank of England’s good work on the sensitivity of financial investments to climate change should be extended. Otherwise, average real interest rates should be held low. Far more important in fairly managing constrained supplies will be the redistribution of real resources – through taxation and subsidies, on one side, and through significant real-terms pay increases for workers on the other. Central banks have little to offer here.