Inflation, recession, or both?

Dr Bryce Wilkinson
NZ Herald
28 July, 2022

Whiplash occurs when the body is moving fast in one direction and is abruptly jerked back in the opposite direction. It can be very painful, lethal even.

Whiplash is what those who borrowed heavily last year to buy shares, bonds or houses will now be feeling. Central banks are at the centre of both whiplash aspects. They induced the extraordinarily low interest rates that led people to borrow more. Now they are moving in the opposite direction. Why impose this pain?

This week the New Zealand Initiative published a report that finds that central banks are largely to blame. They made serious policy mistakes that produced inflation.

The immediate upshot is that consumer prices in New Zealand in June were 7.3 per cent higher than in June 2021, a 32-year high. Britain's inflation rate hit 9.4 per cent, the US 9.1 per cent, both 40-year highs.

Central banks did not forecast such increases, despite their enormous cash injections into their banking systems.

Central banks are now in a bind. They need to lift interest rates a great deal to make their commitment to low inflation credible. But doing so risks recession, high unemployment and many bankruptcies.

The report was co-authored by Graeme Wheeler, a former governor of the Reserve Bank of New Zealand, and Dr Bryce Wilkinson, a senior Research Fellow at the New Zealand Initiative.

The report attributes six mistakes to central banks since 2019. This list explains its call for central banks to honestly and publicly assess what they got wrong. Doing this could help them to credibly commit to restoring price stability.

First, central banks were too confident about their ability to preserve low inflation. Flooding domestic and global banking systems with cash was bound to raise doubts.

Second, central banks put too much faith in models that assumed that the public's inflation expectations were anchored. Models are useful for clarifying thinking but can be unreliable guides to decision-making because they abstract from a much more complex reality.

Third, central banks were too confident that output and employment would respond in a predictable way to cheap money. This is not so. How people react depends on how anxious they are and how they read the situation.

Optimistic people might use it to purchase assets at inflated prices. Some borrow excessively to do so, confident that central banks "have their back". Central banks hope instead that they might spend it on newly produced goods and services. Some will, but how many? Anxious people may hoard money instead. The perceived context of loose money is very important and hard to model.

Fourth, central banks were distracting themselves with non-core issues. Examples include climate change, economic inequality, and in some cases, "indigenous'" issues. They lack expertise in these issues and effective tools for addressing them.

Fifth, government-imposed conflicting objectives on central banks undermine their commitment to price stability. When inflation is high and employment growth is negative, what is a central bank to do? If it does not know, how would investors, workers or employers know?

The last of the paper's reasons for how things have come to this is the role of political pressures on central banks. Incumbent politicians do not want a recession close to the next general election. Nor do they want to see interest payments on the public debt taking 20 per cent or more of annual tax revenues.

Governments have power over their central bank. They can influence or dictate key appointments. They can end or weaken its operating independence. It is difficult to say what role such pressures have had in producing the current debacle. But it would be naïve to rule them out.

Central bank support for government action to assist firms through the Covid-lockdowns in 2020 was necessary. But the extent and duration of the stimulus is another matter.

Despite Covid, asset prices surged for shares, bonds and houses. This was amidst what was forecast to be a major recession. The very modest rate of bankruptcies was another warning sign.

Both the forecasts at the time and the diagnosis were suspect. Covid lockdowns and supply chain disruption caused supply shortages. Increasing the supply of money does not solve such problems. Instead, it sees more money chasing fewer goods. That is not good.

The whiplashing is still in its early days. Central banks have nowhere near extracted the cash they pumped into banking systems. They will have to lift their policy interest rates higher to be credibly disinflationary. In some cases, much higher.

The upshot is that central banks now face an unpalatable trade-off. If they do not now impose pain on the public, they face losing further credibility about their commitment to low inflation.

Investors, workers and employers have to assess which will be their central bank's priority. The greater the number who think it will put avoiding recession first, the more painful disinflation will have to be.

Credibility is easily lost. It is also hard-won. The disinflationary recessions under Margaret Thatcher in the UK and Ronald Reagan in the US in the late 1970s and early 1980s showed how painful it can be. New Zealand's disinflationary experience a decade later is from the same broth.

The prospect of stagflation or worse was anticipated in the New Zealand Initiative's 2021 report "Walking the Path to the next Global Financial Crisis". That report also showed the compounding problem of excessive public debt.

Public debt ratios in the US, UK, Japan, and Italy, among others, are unnervingly high. The US ratio is at a record peacetime high.

The pain ahead will be unevenly distributed. Hardest hit will be the poorer countries that have borrowed heavily in US dollars. Within all countries, it is those with the least means who will likely struggle most.

Central banks can reduce the pain by taking effective measures to restore confidence in their determination to achieve price stability. Frank diagnosis of what went wrong would be a good start.

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