From the former head of the Reserve Bank of India via the University of Chicago, Booth School of Business (where he has a comfy endowed chair) Chicago Booth Review, November 16:
Monetary policy makers set the stage for inflation but were slow to respond when it appeared.
Hindsight is, of course, 20/20. The pandemic was unprecedented and its consequences for the globalized economy very hard to predict. The fiscal response, perhaps much more generous because polarized legislatures could not agree on whom to exclude, was not easy to forecast. Few thought Vladimir Putin would go to war in February 2022, disrupting supply chains further and sending energy and food prices skyrocketing.
Undoubtedly, central bankers were slow to react to growing signs of inflation. In part, they believed they were still in the post-2008 financial crisis regime, when every price spike, even of oil, barely affected the overall price level. In an attempt to boost excessively low inflation, the US Fed even changed its framework during the pandemic, announcing it would be less reactive to anticipated inflation and would keep policies more accommodative for longer. This framework was appropriate for an era of structurally low demand and weak inflation but exactly the wrong one to espouse just as inflation was about to take off and every price increase fueled another. But who knew the times were a-changing?
Even with perfect foresight—and in reality, they are no better informed than capable market players—central bankers may still have been understandably behind the curve. A central bank cools inflation by slowing economic growth. Its policies have to be seen as reasonable or else it loses its independence. With governments having spent trillions to support their economies, employment just recovered from terrible lows, and inflation barely noticeable for over a decade, only a foolhardy central banker would have raised rates to disrupt growth if the public did not yet see inflation as a danger. Put differently, preemptive rate rises that slowed growth would have lacked public legitimacy—especially if they were successful and inflation did not rise subsequently. Central banks needed the public to see higher inflation to be able to take strong measures against it.
In sum, central bank hands were tied in different ways—by recent history and their beliefs, by the frameworks they had adopted to combat low inflation, and by the politics of the moment, with each of these factors influencing the others.
Yet stopping the postmortem at this point is probably overly generous to central banks. After all, their past actions reduced their room to maneuver and not just for the reasons just outlined. In particular, take the emergence of both fiscal dominance (whereby the central bank acts to accommodate the government’s fiscal spending) and financial dominance (where the central bank acquiesces to the imperatives of the market). They clearly are not unrelated to central bank actions of the past few years.
Long periods of low interest rates and high liquidity prompt an increase in asset prices and associated leveraging. And both the government and the private sector levered up. Of course, the pandemic and Putin’s war pushed up government spending. But so did ultra-low long-term interest rates and a bond market anesthetized by central bank actions such as quantitative easing. Indeed, there was a case for targeted government spending financed by long-term debt issues. Yet sensible economists making the case for spending did not caveat their recommendations enough, and fractured politics ensured that the only spending that could be legislated had something for everyone. And, of course, politicians, as always, drew on unsound but convenient theories (think Modern Monetary Theory) that gave them the license for unbridled spending.
Central banks compounded the problem by buying government debt financed by overnight reserves, thus shortening the maturity of the financing of the consolidated balance sheet of the government and the central bank. This means that as interest rates rise, government finances, especially for slow-growing countries with significant debt, are likely to become more problematic....
February 11, 2022
Former Reserve Bank of India Head, Raghuram Rajan: "Central Banks Have to Start to Move"
«We sort of stopped thinking about countries like Italy. But if we come out of the pandemic and interest rates are not at 1% or 2%, but at 4% or 5%, what happens to public finances? Obviously, the biggest risks are always the ones you don’t see. But this is a risk we haven’t paid attention to for a long time»:—Raghuram Rajan.
Long time readers may remember Professor Rajan from such hits as:
Raghuram Rajan on The Boom and Bust in Farm Land Prices in the United States in the 1920s
and:
India’s Central Bank Governor Discusses Robber-Baron Capitalism and a Fine Veg CutletOkay, I'm being a bit whimsical, the man is brilliant and I wish he was running the U.S. Fed rather than sitting in his comfy endowed chair at the Booth School of Business.
Also:
- Raghuram Rajan: "When the Interests of Monopolists and Authoritarians Coalesce"
- Raghuram Rajan: "Disruption, Concentration, and the New Economy"
- "World Out Of Whack: An Absurd Unintended Consequence Of Abnormally Low Rates"
- Fannie and Freddie Must Die! Some guy in Chicago Takes on Paul Krugman's Version of the Mortgage Mess (FNM; FRE)
