The credibility of central bankers is on the line as they stand convicted of having ignored inflation for too long and now must try to contain it against long odds.
While she is no longer chair of the Federal Reserve, it was Treasury Secretary Janet Yellen’s long service at the San Francisco Fed and then the board of governors in Washington that established her reputation as a circumspect central banker.
She has not fared so well in the political arena, and her comments Sunday that a recession is neither imminent nor inevitable may come to haunt her. A cynic would say that all she has to do is express some remorse for being mistaken, as she did earlier this month for getting inflation wrong.
Fed Governor Christopher Waller is belatedly trying to restore his own credibility after going along with the crowd on inflation for too long. He said the Fed will probably have to follow up its surprise three-quarter point rate hike last week with another one in July. As he stated Saturday at a Dallas event:
"The Federal Open Market Committee took another significant step toward achieving our inflation objective by raising the Federal Funds rate target by 75 basis points. If the data comes in as I expect I will support a similar-sized move at our July meeting. The Fed is ‘all in’ on re-establishing price stability."
Fed Chairman Jerome Powell’s credibility has dwindled significantly as he first claimed inflation was transitory and insisted last month that a three-quarter point hike would not be necessary and was not something policymakers were considering.
As President Joe Biden passed the buck on inflation to Powell, the Fed chairman passed it to “external forces” and to “factors that we don’t control.”
So, there is a consensus among US policymakers—this isn’t our fault.
However, that’s not the way it works. Just ask Arthur Burns, the Fed chairman who ushered in a long period of inflation in the 1970s, claiming all the while that inflation was out of the control of the Fed. But history has given him the rap for inflation.
As Richmond Fed economist Robert Hetzel wrote in an analysis of Burns’ policy in 1998:
"Burns conducted monetary policy on the assumption that the price level is a nonmonetary phenomenon. The Congress and the administration, public opinion, and most of the economics profession supported that policy. The result was inflation. That inflation eventually led to the present consensus that the control of inflation is the paramount responsibility of the central bank."
ECB Hastily Proposes New Sovereign Bond Arbitrage
In Europe, the governing council of the European Central Bank belatedly realized that tightening monetary policy at this late date would lead to a greater divergence in government bond yields, creating a fragmentation among euro members and widening the spread between weaker and stronger countries.
Last week, the ECB hit the panic button and held an emergency policy meeting on Wednesday. Funds from maturing bonds in the pandemic emergency purchase program would be reinvested in bonds of Italy and other highly indebted countries, it announced, while ECB wizards will speed up with proposals for a new asset purchase program to support those weaker countries.
One of those plans is to sell the bonds of strong countries like Germany to buy bonds from countries like Italy without forgoing the quantitative tightening deemed necessary to contain inflation. This arbitrage could be announced at the ECB policy meeting in July.
Olli Rehn, the outspoken head of the Finnish central bank, subsequently warned, however, that while the ECB could limit the rise in yields for big eurozone debtors, it could not fix their debt problems.
At a Dallas Fed event, Rehn reminded everyone that the ECB has something called Outright Monetary Transactions—a tool to bail out member countries, that has never been used because it requires them to undertake painful reforms.
In any case, Rehn said, the ECB is committed to preserving central bank independence, and will not let politicians dictate its monetary policy:
"While fiscal-monetary interaction is a basic feature of policy coordination in a currency union like the eurozone, it cannot be in contradiction with the independence of central banks. We are fully committed to preventing fiscal dominance – and/or financial dominance, for that matter. All our measures will be taken on the grounds of our mandate, which is to safeguard price stability, and in line with our monetary policy objectives."
Rehn is well aware, however, that there are those on the 25-member governing council who may not be so committed to an independent monetary policy.