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  • How Central Banks Won the Battle But Lost the War

How Central Banks Won the Battle But Lost the War

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Bloomberg Sep 13 04:34 · 25.4k Views

In the battle against inflation, central banks used to be the lone hero. But missteps in managing the post-pandemic price surge, and rising risks as war, tariffs and climate shocks cause supply shortages, mean that in the future the fight may be more of a team sport.

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Transcript

  • 00:06 The Wizard of Oz, the classic children's story by Frank Bald, is partly about monetary policy.
  • 00:13 There's a famous moment where Dorothy's dog Toto pulls back the curtain and reveals the Wizard to be just a man with a light speaker.
  • 00:23 The Great Oz
  • 00:24 has
  • 00:24 spoken.
  • 00:25 In a way, the COVID pandemic and the inflation that followed has been a Wizard of Oz moment for the Fed and the ECB and the Bank of England and other central banks.
  • 00:36 We thought they were maestros, all powerful geniuses.
  • 00:40 Then came the COVID shock.
  • 00:42 The lockdowns of the pandemic caused severe supply shocks as factories shuttered around the world.
  • 00:49 Meanwhile, government stimulus meant to keep the economy afloat
  • 00:53 drove a surge in inflation.
  • 00:55 Central bankers were slow to recognize that inflation was taking off.
  • 01:01 And after it did take off,
  • 01:03 they didn't have the tools to bring it quickly under control.
  • 01:07 To the Fed's credit,
  • 01:09 when they decide they have to make this course correction by raising rates rapidly, they did go for it.
  • 01:15 Powell was very clear that they will do whatever it takes to
  • 01:19 bring price stability back.
  • 01:21 I think right now many people thought that the Fed has redeemed
  • 01:25 themselves,
  • 01:27 but at the same time the world has changed.
  • 01:30 Central banks
  • 01:31 have won the battle to get inflation back to their 2% target.
  • 01:36 In the years ahead,
  • 01:38 we may discover that they have lost the war over how management of inflation works.
  • 01:50 When interest rates go up, it becomes more expensive to borrow, and that means less spending, less demand.
  • 01:57 The economy cools
  • 01:59 and inflation comes down.
  • 02:00 And
  • 02:01 when the problem isn't too much inflation but rather too much unemployment,
  • 02:06 central banks do the reverse.
  • 02:08 They cut interest rates.
  • 02:10 They make it cheaper to borrow
  • 02:12 and that increases demand and it gets the economy going and creates more job opportunities.
  • 02:19 I would compare monetary policy as the Fed manipulating a kite.
  • 02:24 Ultimately, it's at the end of that kite which really affects the economy in the US.
  • 02:30 To ensure that banks have enough money to cover withdrawals,
  • 02:33 they're required to keep some reserve cash with the Federal Reserve.
  • 02:37 The Fed's policy tool is an interest rate called Federal Funds Policy rate, And so by changing that fed funds rate level, it will affect the short term interest rate that banks will charge to each other and eventually to other small businesses or large businesses.
  • 02:54 Central banks controlling the flow of credit has been the preferred method of governments to ensure price stability for decades.
  • 03:01 But trade wars, actual wars, and climate change
  • 03:04 means the new risk to inflation comes from supply shocks.
  • 03:09 China's entry into the global trade system was a major disinflationary shock.
  • 03:16 That is not the world we're living in anymore.
  • 03:19 China is getting more expensive, and frictions between China and the United States means
  • 03:25 that globalization tailwind for disinflation is turning into a
  • 03:32 deglobalization
  • 03:33 driver of higher prices.
  • 03:36 We now live in a world of
  • 03:39 hot wars.
  • 03:40 Russia invading Ukraine
  • 03:42 and turning off gas supplies and oil supplies for Europe and expanding conflict in the Middle East.
  • 03:49 End of lockdown.
  • 03:50 Inflation
  • 03:51 was amplified by higher energy prices,
  • 03:54 especially in Europe
  • 03:56 but also around the world.
  • 03:58 Climate change is also part of the picture.
  • 04:01 Carbon taxes would help with the fight against climate change, but they would also be adding to inflationary pressure.
  • 04:09 The Fed's policy tools can only raise or lower aggregate demand.
  • 04:14 It is not meant to affect supply in the economy.
  • 04:18 So what can affect supply in the economy?
  • 04:21 Well, fiscal policy can.
  • 04:23 Tax policy can.
  • 04:24 So there's a big debate on the way about what new tools are required to control prices and keep inflation low and stable.
  • 04:33 And many of those tools are being built outside of the remit of central banks.
  • 04:40 The pandemic economy has proved to be unlike any other.
  • 04:44 There remains much to be learned from this extraordinary.
  • 04:47 One lesson for central banks is that keeping inflation on target is going to get tougher to do.
  • 04:53 We've just been through a period
  • 04:55 where inflation didn't stay at that 2% target.
  • 04:58 And that's a world where the political support for strong independence.
  • 05:03 Pendant central banks is far from guaranteed.
  • 05:06 There are troubling signs that unemployment is starting to rise.
  • 05:10 And that means it's a turning point for the US economy and a turning point for the Federal Reserve.
  • 05:16 What happens to the status of the Fed under a second Donald Trump presidency?
  • 05:22 Would the Fed retain its strength and its independence Oregon.
  • 05:26 Would it find itself subject to greater political pressure to set monetary policy?
  • 05:33 According to
  • 05:34 the electoral calendar, we estimate that 80% of the consumers are feeling financially stretched.
  • 05:40 People are paying well over 20% on the credit card bill.
  • 05:44 And so once the feds start cutting rates, then the interest rate on the credit cards will come down.
  • 05:50 But at the same time,
  • 05:52 if the Fed generates a recession and if you lose your job,
  • 05:56 then how are you going to pay?
  • 05:57 This is the reason why it's
  • 06:00 kind of critical for Powell
  • 06:02 to restore price stability
  • 06:04 and generate a soft landing.
  • 06:06 Since World War 2, the Fed had only been able to successfully generate a soft landing
  • 06:14 perhaps once.
  • 06:15 In 1995, Alan Greenspan
  • 06:18 was the Fed chairman, and then with Paul Volcker, he did exactly the opposite.
  • 06:23 He actually brought forth a very deep recession in the US economy in the 80s, yet he was still lionized for
  • 06:31 slaying the inflation dragon.
  • 06:34 The lesson from Volcker and Greenspan is that a central bank's reputation really depends on whether they prove to be steady hands on, keeping price ability under control while allowing the economy to grow.
  • 06:49 And the unfortunate thing is I think Powell today still faces a tension between high inflation risks
  • 06:57 and also lower growth.
  • 07:00 We're living in a world which is swung from globalization to deglobalization
  • 07:05 and where climate change is a new and important factor.
  • 07:10 I think in the future we're not going to be talking about maestros
  • 07:14 and Central Banks might be the captain of the team,
  • 07:18 but they won't be the only player.