Central banks, led by the US Federal Reserve and the European Central Bank, are losing credibility as they stubbornly insist that inflation is transitory and it is all right for them to sit on their hands. Even if they are correct that inflation will subside sometime next year, inflation that increases over the period of a year can hardly be called transitory.
Mohamed El-Erian, the former CEO of Pimco who tracked inflation and interest rates for some of the world’s largest bond funds, was scathing in a Financial Times comment on the latest jump in the US consumer price index, which rose 6.2% on the year in October.
He details what he calls “behavioral traps” that make central bankers so stubborn:
“In this case, they include inappropriate framing, confirmation biases, narrative inertia, and resistance to a loss of face. Yet, its persistence in the face of repeatedly contradictory data seriously increases the risk of otherwise-avoidable economic, financial, institutional, and social damage.”
That was severe criticism, but El-Erian went further on Friday: “There are lots of structural changes going on in the post-pandemic economy,” he said on Bloomberg TV. “You can't simply dismiss them as transitory. So it is going to go down in history as one of the worst inflation calls by the Federal Reserve.”
Costs Of Going Green
ECB chief economist Philip Lane doubled down on the central bank’s line in an interview last week with Spain's El País:
“This period of inflation is very unusual and temporary, and not a sign of a chronic situation. The situation we are in now is very different from the 1970s and 1980s.”
Bank of England Governor Andrew Bailey is not getting great press now after he apparently misled investors about an imminent rate hike ahead of the UK central bank’s policy meeting earlier this month, and he reaped more criticism for pointing out what is obvious to anyone who thinks about it—the effort to reduce carbon emissions will fuel inflation.
“I think we are already seeing some effects from climate change on prices now,” Bailey said in an interview with the BBC, citing the sharp increase in natural gas prices as users abandon coal. “As we substitute out of more damaging hydrocarbons, coal obviously being a case in point, during the transition, we will probably see increased demand for some other hydrocarbons [i.e. gas].”
Bailey, who was a delegate to the COP26 climate conference in Glasgow, believes the transition is necessary, but the public needs to be clear about the costs, and one of those costs is likely to be higher inflation.
Fed's UIG Showing Increases 'Sticky'
Despite protestations from Fed Chairman Jerome Powell that the current bout of inflation is related to temporary disruptions from COVID-19 in supply chains and labor markets, the Fed’s own measure of underlying inflation—the so-called underlying inflation gauge—focuses on “the persistent common component of monthly inflation” and it's showing a strong increase in sticky inflation with a current reading of 4.2%.
In fact, as investment strategists note, the UIG belies Fed claims and conventional wisdom that we have been through a long period with inflation below the Fed’s longtime target of 2%. Rather, the “prices-only” measure of UIG has generally hovered at around 2% since the financial crisis, until this year’s sharp increase. No need to tolerate a period of higher inflation to achieve a 2% average over time.
Ironically, the spike in CPI inflation may work in Powell’s favor as President Joe Biden weighs whether to nominate him for a second term. However mistaken he may be about inflation in the view of his critics, he is widely viewed as less dovish than Lael Brainard, the only Democrat currently on the board of governors and the most viable alternative to a Powell renomination.
Biden’s approval rating is plummeting and rising inflation is one of the reasons. In a rational world, a Fed chairman who is more hawkish or at least less susceptible to political winds might be an option, but US politics is anything but rational right now, so the less hurtful choice to keep a rein on inflation might be to reappoint the current chairman.
Two of the doves on the Federal Open Market Committee, Neel Kashkari at the Minneapolis Fed and Mary Daly at the San Francisco Fed, said last week they don’t expect any clarity on inflation until the Fed finishes tapering off its asset purchases next summer. Just be patient, they said, because raising rates too soon would hurt the job market without doing much to curb inflation.
What if they’re wrong and El-Erian is right? History will be the judge, but voters in the 2022 midterm elections next year will also have a verdict.