Questions for central banks as the world approaches a new era

Tuesday, 31 May 2022

Adrian Orr has said that interest rates were returning to normal after being low during the Covid pandemic.

Dileepa Fonseka is a Stuff writer on business and politics.

OPINION: To the casual observer central banks fighting inflation can look a bit like kicking somebody while they’re already down for the count.

Economic confidence is plunging on the back of soaring inflation, inflation is high because there are major supply constraints and people are grumpy because they feel like they can afford less of the lifestyle they once had.

So central banks around the world are solving the problem by digging the boot in a little deeper and raising interest rates so that people can afford even less.

Not surprisingly, it’s causing a tremor of dissatisfaction around the globe – a trend ANZ chief economist Sharon Zollner sees as only increasing in ferocity over time.

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“It’s not that political yet, but as evidence mounts that monetary policy is slowing things down and causing economic pain – which is what it is aiming to do – then I would expect the noise around that to increase, and that’s globally.”

Attempts to stoke inflation through quantitative easing eventually created asset bubbles.

New Zealand has not been immune, over the last two years we have seen political pressure in different directions: National and Act calling for the Reserve Bank’s remit to narrow to exclude unemployment to keep inflation low, then Labour and the Greens making noises about wanting the Reserve Bank to take asset price – and wealth redistribution – effects into account when they lower interest rates.

This week the country is entering a long period of consultation on central bank policy, with the Reserve Bank going out to the public with its monetary remit.

The gains of the current monetary policy regime were hard-won through the 1980s and 1990s with a regime of inflation-taming interest rate hikes, but Zollner says the history of central banks is that various models for operating them only last for about 30 years before they are replaced by something else.

“We’ve sorted out that the nicest way to run a country is a democracy, we’ve sorted out a lot of basic stuff, but we don’t seem to be able to figure out the best way to run a monetary system.

“We keep trying different things, and they tend to last about 30 years and then fall over.”

Have central banks performed well within the current era? Their policy settings meant that globally they spent a lot of time trying to reflate economies because deflation was driving down prices – and attempts to stoke inflation through things like quantitative easing eventually created asset bubbles.

Was the problem of deflation terrible enough to justify the side effect of higher asset prices? Was there another way?

Sharon Zollner sees global political tensions rising around monetary policy and inflation.

Looking ahead, if you think of the current inflation crisis as a dry-run for future ones, then are other causes for concern.

Fighting climate change will undoubtedly involve a massive hike in energy prices to encourage people to switch from one form of energy to another.

Energy fuels our society, and if this crisis has taught us anything it is that when energy prices go up then the cost of a whole range of commodities and goods go up as a result.

In practical terms it means if future governments want to make the cost of more carbon-intensive forms of energy more costly, then those effects are going to ripple through into higher prices right across the economy.

And while central banks might decide to ignore the immediate effects of a government policy-related price rise, they would surely have to pay attention to all the price rises that might follow from that.

“There’s a tension between inflation-targeting and climate goals, because we need the world price of carbon-based energy to be significantly higher in order to drive behavioural change,” Zollner says.

“And yet, when the price of carbon-based energy went higher the Government cut fuel taxes because the impact on low income earners is vicious.”

An essay from University College London sustainable finance policy fellow Katie Kedward argues higher interest rates also threaten the transition to green energy by making it costlier for firms and governments to invest in less carbon-intensive forms of energy – investments which often carry a high upfront cost.

“It is often said that, when given a hammer, everything looks like a nail – an adage that unfortunately sums up the current consensus on inflation control,” Kedward writes.

“Yet not only do central banks have far more tools in their arsenal than rate hikes, but they should recognise that monetary policy cannot be seen as isolated from the cost-of-living crisis and the energy transition.”

Zollner wonders if in the longer-term central banks around the world might start simply having to widen the inflation target so that banks aren’t forced into harsh measures that squeeze an economy while it’s experiencing these sorts of price rises.

The problem is this flies in the face of the philosophy behind our inflation targeting regime, because by doing this you are embedding the expectation of higher rates of inflation.

As always, the issue is not so much whether the current regime is good or not, but what you would replace it with, and how.