Inflation, defined as a sustained increase in the general price level in an economy, has been escalating worldwide since mid-2021, (Wikipedia Contributors, 2022) with many countries’ consumer price indices surging well above 3% in 2022, the top-end of the 2% +/- 1 target of most central banks. Prolonged high inflation is a dangerous phenomenon since it diminishes consumers’ purchasing power, particularly for those who are paying fixed interest rates on loans, receiving fixed interest rates on pensions, or those whose nominal incomes fail to rise at the rate at which prices are increasing. The result is a fall in their real income- earnings adjusted for inflation- and a subsequent lower standard of living for consumers (Öner, 2011).
There is much debate about the factors to blame for the exacerbation of the current inflation episode, and the usual culprits in the media are international events such as the COVID supply-chain disruptions and public-health related labour shortages, the post-pandemic demand spike and more recently, the supply shocks resulting from Russia’s war in Ukraine and Brexit (in the eurozone) (Morgan, 2022).
In my article, I will explore these events in more depth and their role in contributing to the present level of inflation, however, I seek to emphasise the actions taken by various central banks (the Bank of England (BOE), the European Central Bank (ECB) and the Federal Reserve) in attempting to maintain price stability during these periods, given that this is a key function of these important financial institutions (Tejvan Pettinger, 2017). Despite the responsibility they have and the mechanisms they can control – such as the base rate and issuing of money- central banks have seemingly failed to keep inflation at its target level since mid-2021 and yet are rarely held accountable, unlike international events, for the current inflation episode. Is this lack of blame justified?
Ultimately, through my evaluation of their response to these events in the last couple of years, I conclude that to solely inculpate central banks for high inflation is misguided; they have implemented the correct monetary policy tools at each stage considering the limited extent of their power in the face of largely supply-side root causes. Yet, the vigorous rate and large scale at which certain policies were (and are being) carried out have either worsened inflation or failed to reduce it, making them partially culpable for the ongoing general price increases.
During the COVID-19 pandemic, the global economy experienced its largest recession since the Great Depression of 1929, even worse than that of the 2008 financial crisis for many states (Gopinath, 2020). More than a third of the global population was placed into lockdown and an estimated 400 million full-time jobs were lost across the world, causing income earned by workers globally to fall by 10 percent in the first nine months of 2020 alone (Vincent, n.d.). Subsequently, these ‘stay-at-home’ economies were faced with a combination of negative supply-side and demand-side shocks; both their capacity to produce goods and services and consumers’ willingness and ableness to buy these products fell drastically, as highlighted by the example of the ongoing global shortage of semiconductor chips (Wikipedia Contributors, 2022a). Forces like globalisation have contributed to the supply-side shock caused by the pandemic, by making long supply chains well-structured, yet difficult to manage; at one end, the initial fall in economies’ aggregate demand resulting from the pandemic has caused much larger decreases in production on the other- a sort of ‘decelerator effect’ (Siripurapu, 2021).
Establishing this blend of supply and demand shocks is important when considering monetary policy design during the pandemic, since whilst such policy can reduce the impact of lowered aggregate demand, other actions are often needed to combat supply shocks (Brinca, Duarte and e Castro, 2020). With this in mind, an assessment of central banks’ initial response to the COVID crisis can be carried out.
In March 2020, central banks implemented two major policies to avoid amplifying the recession. Firstly, both the BOE and the Federal Reserve reduced their base rate by 65 points to 0.10% and by 100 points to 0-0.25% respectively. This form of expansionary monetary policy was carried out to boost aggregate demand by making people more willing and able to take out loans and mortgages from financial institutions and create more rounds of spending in the economy. However, the ECB maintained its reference rate at -0.5% to refrain from venturing further into the previously untested policy of negative interest rates and damaging commercial banks’ profit margins (Ferrero, 2020).
The second form of expansionary monetary policy pursued by all three of the aforementioned central banks in this period was quantitative easing- the BOE, the Federal Reserve and the ECB purchased over £400 billion, over $700 billion, and over €1.4 trillion (respectively) in government bonds, treasury bills and other securities in the open market to provide liquidity to the financial system and support aggregate demand. This in turn bid up the price of such securities, lowering yields for investors and encouraging them to invest in riskier assets that help boost the capital market. The policy also helped keep interest rates low as other banks sought to provide customers with competitive rates on loans (Ferrero, 2020).
To evaluate these methods of control, on one hand, it seems that the central banks in 2020 acted quickly and in accordance with one another to maintain an appropriate flow of credit in the global economy and incentivise banks to keep lending to consumers in spite of the COVID recession, thus preventing the aggravation of the economic downturn from the pandemic.
However, due to the current high levels of inflation, critics of the COVID-period monetary policy, like the ex-BOE governor, Mervyn King, blame the scale of the increase in monetary supply through expansionary monetary policy for the general price level hikes we have seen over the past months (Milliken, 2022). He likely agrees with Milton Friedman, who famously said ‘(persistent) inflation is always and everywhere a monetary phenomenon’- in this case, after the post-pandemic demand spike, although supply chain shocks were the initial drivers of inflation, ultimately, increasing the money supply to a level greater than the output in an economy through quantitative easing and very low interest rates is what has caused the continuous high inflation of today since there is too much money available to buy a similar amount of goods and services. This is highlighted by the equation:
MV = PQ
(Money supply x Velocity of money = Price level x Quantity of output) (Wen and Arias, 2014)
Such a claim can be supported by figures which show that since the COVID crisis, the money supply has grown by 40% in the US, 22% in the UK and 20% in the eurozone (Boyle, 2021).
Yet, money velocity has actually decreased in these regions in the last decade, particularly during the pandemic lockdown as consumers increased their involuntary and precautionary savings. (Stevens, 2021) This argument is often pursued by Keynesians to criticise the quantity theory of money, strengthened by the idea of a natural decrease in money velocity as supply increases, since each unit of currency is exchanged less on average when more units are available (Barone, 2022).
In response, Monetarists claim this isn’t sufficient to offset the effects of the huge increase in money supply on price levels. This, they would assert, combined with the fact that the quantity of output (Q) in each of the regions has decreased due to supply shocks as money supply, clearly points to monetary policy as a main cause of the current inflation episode.
The central banks’ lack of tightening of money supply (e.g., the BOE only stopping bond purchases at the end of 2021) perhaps came from the belief that the initial surge in the general price level was a temporary consequence of the supply chain mess, a belief held by the Federal Reserve, the BOE and the ECB in early 2021 (Austin, 2021), (Wickens, 2022), (Reuters, 2021). When central banks hold such views, dangerous ‘second round effects’ ensue- rapid real wage growth in countries with strong labour markets as people’s inflation expectations worsen and trust in central banks to carry out their price stability mandate decreases. When wages increase quicker than a firm’s ability to absorb these costs, these costs are translated into higher prices, a phenomenon that has worsened built-in inflation and today’s high consumer price index (Wickens, 2022).
Following the supply-side and demand-side shocks of the COVID pandemic, Russia’s ongoing war in Ukraine escalated into a mainland invasion in February 2022, and intensified the hit to global supply, notably driving up energy and food prices as a result of the trade restrictions from economic sanctions imposed on Russia (Macchiarelli, 2022). More specifically to the UK, after Brexit and between 2019 to 2021, there was a 110,000-person fall in the number of EU nationals employed in the UK (ONS, 2022) increasingly narrowing the labour market, and causing firms’ costs of production to rise as UK workers demand higher wages than those of their European counterparts.
Central banks responded to these negative supply shocks by raising interest rates to dampen aggregate demand and attempt to control price levels; the BOE initiated this in late 2021 when the base rate was increased from 0.10 to 0.25%, but they have continued hiking rates aggressively in 2022. The Federal Reserve followed suit in early 2022, initially raising the federal funds rate from 0.25 to 0.50% and more recently, beyond 4.00%. The ECB, however, began its tightening later in 2022, raising the eurozone interest rate to above 0% for the first time in over a decade after concluding its quantitative easing programme in the summer (Ferreira, 2021).
Critics of the policy of increasing interest rates, which is largely suited to mitigating the inflationary pressures from positive demand shocks, would argue they are not useful in combating the aforementioned negative supply-side shocks (Dayen, 2022); rather, higher rates diminish business confidence, make firms less likely to carry out riskier purchases and invest in capital, and thus aggravate existing supply issues (Pettinger, 2021). In addition to this viewpoint, some argue that central banks’ priority of controlling inflation has pressured them to overreact when increasing interest rates, despite price instability being a mostly supply-side problem; this ignores the second mandate of independent central banks, which is to support general macroeconomic objectives like economic growth and low unemployment, which are negatively impacted in the long-term by rapid rate hikes. Furthermore, considering that energy prices are the key drivers of the current inflation episode, opponents of huge increases in the base rate would encourage central banks to help their governments invest in a more reliable energy system by lowering rates and reducing borrowing costs for such initiatives, hence securing price stability in the medium to long-term (Van Gaal, 2022).
However, supporters of these rapid tightening policies from late 2021 may argue that they are necessary to reduce the money supply in the global economy to lower inflation, particularly as post-COVID pent-up demand is still prevalent in many industries such as travel and tourism (Price, 2022). They would add that central banks have somewhat of a ‘blunt toolkit’; they cannot control supply-side policies to increase an economy’s productivity and efficiency in the way governments can- the latter can engage in free-market or interventionist policies to shift aggregate supply (Smith, 2022). Lastly, it can be proposed that, due to the independence of monetary and fiscal policy in many economic regions (including the US, UK and the eurozone), the clash of the two can reduce the intended effect of monetary policy on inflation. An example to demonstrate this is former UK chancellor, Mr Kwarteng’s ‘Mini-Budget’ of September 2022, which sought to improve economic growth through tax cuts, yet directly offset the BOE’s attempts to reduce aggregate demand through interest rate hikes (Wikipedia Contributors, 2022).
In conclusion, it is evident that there are varying stances on the extent of central banks’ culpability for the current inflation episode. Given that this episode, from mid-2021 to 2022, initially came about due to massive supply shocks to the global economy, those who have praise for monetary policy in the last couple of years emphasise that the central banks have less power over price stability than is generally assumed and that the main policy tools to control inflation (raising interest rates and increasing the money supply) are effective only against positive demand-side shocks. It’s also important to note that financial integration as a result of rapid globalisation over the past decades makes supply chains more vulnerable to disruptions than ever, rendering central banks even less influential in maintaining prices (Wolf, 2015). Further support of central banks’ actions includes acknowledgement of the difficult balance they had to strike in the wake of both the post-COVID boost in demand and the previously mentioned supply shocks; approaching 2022, excessive tightening could risk another recession and excessive easing could negatively influence inflation expectations, ultimately driving it up.
However, I feel it is important not to ignore the scale and intensity with which central banks carried out quantitative easing during the COVID-pandemic, with many ignoring the lag with which monetary policy takes full effect (roughly 18 months) (Batini and Nelson, 2001) and continuing asset purchases after their economies had regained strength, thus, according to the monetarist’s view, increasing money supply well-beyond the quantity of output. Alongside the policy of slashing interest rates aggressively to decade-lows by the BOE, ECB and the Federal Reserve, this resulted in the demand spike after the pandemic being amplified and adding to demand-pull inflation. More recently, the hasty hiking of rates in 2022 in response to solely supply shocks like the Russia-Ukraine war, was in my opinion, not entirely necessary nor effective, and increases of fewer base points could’ve been carried out to safely reduce aggregate demand without the risk of hurting economic growth in 2023/4.
Hence, whilst I acknowledge the convenience of hindsight when criticising the scale and rate of various monetary policy decisions, I believe, despite enacting the correct policy tools to support the economy at different times, central banks could have done so less vigorously and with more foresight as to the future impacts (or lack thereof in instances of purely supply-shocks) of their decisions on the inflation rate. This, I would argue, makes them blameworthy to some extent for the current inflation episode.
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