This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists
After several decades of low and stable inflation marshalled by independent central banks, 2022 was marked by prices accelerating to 40-year highs across the world. Monetary policymakers have scrambled to raise interest rates over the past 12 months to get inflation back under control. Meanwhile global events — including the pandemic, supply chain snags and Vladimir Putin’s invasion of Ukraine — have brought unprecedented uncertainty to the already inexact science of monetary policymaking. Scrutiny on central bankers has amped up.
Ricardo Reis, professor at the London School of Economics, is an expert in monetary economics and has spent considerable time examining how central banks fell so far behind the inflation curve this year. He published a widely cited paper in June outlining his findings. We discussed this alongside his views on the next steps for central bankers just as it seemed global inflationary pressures may be reaching their apex.
This inflationary episode has led many to question whether central banking tools and remits are outdated, and if price growth will ever return to their 2 per cent targets. Raising interest rates on the cusp of a recession in the middle of a cost of living crisis has also not been ideal, even if necessary. In this discussion, Reis explains how monetary policymakers will navigate the trade-offs ahead, and gives clues about how central banking may evolve, reflecting on the missteps of 2022.
Tej Parikh: Part of learning how to improve is accurately diagnosing what went wrong — so what are your hypotheses for why central bankers fell so far behind the inflation curve this year?
Ricardo Reis: Ultimately, we had a lot of very bad shocks together with a few missed judgment calls on the part of central banks. The shocks were getting surprised by the speed of the recovery from the pandemic, the supply chain disruptions and the energy crisis, while the missed calls were not putting enough weight on how the productive capacity of the economy was affected, not wanting to revert on previous promises to keep monetary policy loose and not paying enough attention to inflation expectations data. This meant that inflation rose more and was more permanent than what it might have been.
TP: The preceding decades of low and stable inflation must have played a role too.
RR: On the side of policymakers, there should be some genuine introspection to see to what extent group think led to some choices or not. For academic economists, I worry there was an over-reliance on data as opposed to theory. If for 30 years inflation was 2 per cent with blips up and down, any empirical model is going to say that if you have inflation going up to 5 per cent, it is going to come down really quickly too.
At the same time, a theorist of monetary policy who is thinking about economic mechanisms saw a lot of red flags and worried that the 5 per cent would persist. Empirics is wonderful when we’re in a stable and steady regime; theory is what you need when you have big shocks and possible regime changes.
TP: Bundesbank president Joachim Nagel recently said we were “seeing our economic models coming up against their limits”.
RR: Economics has made a giant leap forward in the last twenty years by using more and more micro data. However, in the past 18 months I saw too many people so obsessed with the data that they forgot about the theory of central banking and the ultimate fundamental determinants of inflation. Strong theoretical priors and principles should have kept all the big data and machine learning more disciplined than it did. The big forecast errors of “team transitory” 18 months ago seemed to come from putting too much emphasis on micro data and so mistaking the forest for the trees.
TP: Central bankers also had to make a number of judgments on issues outside their usual expertise; epidemiology, supply chain dynamics, and geopolitics.
RR: At the end of the day, policymakers are going to get different scenarios from their staff and they are going to pick one. And it turns out that I think they picked the wrong one a couple of times in a row, and that led to inflation getting so much out of hand. I don’t think this tells us the overall framework is flawed. And I am hopeful the success of the next twelve months bringing inflation down will prove that.
TP: But do they need to build more capabilities beyond the economics discipline?
RR: There is no lack of human capital inside central banks, and central banks are, among all policy institutions, the ones that use outside knowledge more effectively.
On which knowledge, if anything, I would say that at a time like now, where over the next two years the big challenge is to bring inflation down, I’d want to have the more hardcore, monetary, economic theorists in the building, that understand inflation and what drives it. Maybe afterwards we can have that discussion of broadening capabilities beyond economics, but right now I’d focus on the core business.
TP: Do central bankers even have the right toolsets to meet their inflation targets, given the “long and variable” lags through which the policy rate operates?
RR: If we had raised rates earlier, we wouldn’t have had so much inflation now. So, I would say the answer to your question is no, I think the toolkit is up to the job. In an environment where interest rates were very low and hitting zero lower bounds, there was a need to expand the toolkit in order to provide more stimulus. This was the discussion around quantitative easing, forward guidance and yield curve management. All of that was very useful, and it should be anchored by always talking about interest rates since interest rates control inflation.
When we do forward guidance, QE and whatnot, you are just trying to affect interest rates at different horizons. Right now you can do QT, but in the end, since it is about interest rates, you can just raise the policy rates and I think that will be enough to bring down inflation. In other dimensions of the toolkit, note that you want to raise rates without breaking things along the way. That requires macroprudential tools and lender of last resort so that you can stop runs in some financial markets. It also requires central bank swap lines to keep international capital flows for funding markets from collapsing. And, it requires more communication.
TP: Yes, and it also takes time to understand how other tools should be optimally calibrated, reflecting on QE.
RR: For a decade, the size of central bank balance sheets and rates moved in the same direction. But the theoretical prior for doing QT when raising rates is not really there. In fact, right now probably the adequate thing to do would be to raise rates, keep the balance sheet stable and be ready to expand the balance sheet to address cracks in the financial system that may happen. The central bank balance sheet is primarily a financial stability tool, and only then an inflation tool.
TP: What about the inflation target itself: the climate transition, shifts in globalisation, ageing populations, and state spending pressures could keep prices higher. Is there an argument for saying let’s aim for above 2 per cent instead? Do you think we are moving into a new inflation regime altogether?
RR: There is definitely an argument, but there is also a big risk. Firms, wage setters, price setters, speculators, professionals at banks, everyone thinks that inflation is going to be at 2 per cent in the medium-term.
That is a strong anchor and gives me confidence that central banks will succeed. So, let’s first deliver on that before talking about a new target. Then, later, as inflation comes down close to 2 per cent, are there good reasons to ask whether, given the structural changes in the economy, [it would make] more sense to have an inflation target of 3 per cent? The answer is probably yes.
TP: I guess that is also how you feel about those discussing nominal GDP targeting now too.
RR: I’m an academic, so I think we should be discussing everything at all times. But a policymaker faces the constraint that people have a limited attention span. In their shoes, I would not spend time on any speech in the next 12 months on nominal GDP targeting or whether the right inflation target is 4 per cent. After we have brought inflation down, yes let us discuss it, and I am very open to nominal GDP targets as a possibility (although I don’t think it would be a complete game-changer).
TP: Sure, remit changes before we get back to target risks tarnishing central bank credibility. Right now there is also a reputational issue of raising interest rates further as we enter a recession. How do central bankers balance that, with the need to maintain credibility of meeting the target?
RR: Looking forward, it looks like credibility is not tarnished because longer-term inflation expectations are anchored. And we must remember that the recession of next year is caused by Putin’s invasion of Ukraine, not by the hiking of interest rates by central banks. A recession was always going to happen for the eurozone and UK, which are large net importers of energy. There’s not much that central banks could do about that. Their mandate is not to avoid recessions. Their mandate is to meet the inflation target.
Of course, there needs to be a sensible balancing of bringing inflation down without breaking things along the way. Central banks should not cause deep recessions, financial crises and sovereign debt crises. Interest rates are being raised, and that is lowering inflation, and it is posing challenges to other parts of the economy, but it is not causing breakdowns, so I think credibility will remain.
TP: How central bankers communicate their policy plans and the trade-offs seems key here.
RR: Communication is always key, because monetary policy works by affecting expectations, and it is important for your legitimacy that you explain what you’re doing and why. But communication is made of talk and actions. The priority is to deliver low inflation, not just to talk about it. Above all, this is what will reassure people that they can count on the 2 per cent inflation when making their long-term plans. There has been, in my view, a communication success in the past six months as major central bankers, like Christine Lagarde, Andrew Bailey, and Jerome Powell have both raised rates and publicly stated that they are committed to delivering inflation of 2 per cent. We have seen expectations of inflation come down as a result.
TP: Is part of the credibility challenge that we are simply asking too much of central banks? In recent years there’s been discussion around central banks and their role in inequality, climate change and so on.
RR: I’m quite open-minded, unlike many of my colleagues who tend to be more critical of that mission creep. As long as they deliver on inflation, I’m fine with central banks having secondary roles.
TP: But wouldn’t more goals beyond inflation targeting mean more tools, and more complexity?
RR: Yes, I can have secondary tools and secondary objectives providing they will not influence the way I set the main tool of interest rates for the main objective of inflation.
TP: Relatedly, the interaction with fiscal policy objectives has also come more sharply into focus. That will probably be an ongoing issue as demands on the state grow.
RR: Interactions between monetary and fiscal policy are a key driver of inflation. That is not to say that we shouldn’t have an independent central bank monetary policy and independent fiscal authority. In fact that status quo over the last 20 years has worked, as central banks independently targeted inflation, while understanding that many of their actions have spill-overs to fiscal policy. Looking forward we have a lot of public debt coming out of the pandemic and I worry that real interest rates on public debt are persistently going to be higher. So that fiscal monetary interactions are going to become more important.
TP: Right so looking ahead, there are three ways in which central banks are broadly calibrating the current rate hiking cycle: how fast, how far and for how long. How do you see central bankers choreographing that?
RR: On the pace, I think the central banks are doing it just right: a sequence of rate hikes of 50-75 basis points to catch up with past delays, and starting now to have 25-50 increases instead. On the peak, when you have inflation well above your target, the way to bring it down is to overshoot relative to where you think interest rates are going to be in the long run. By how much depends on both inflation and measures of expected inflation. Finally, once you’ve overshot, then experience shows that you can lower rates relatively quickly, so you don’t stay at the peak for long.
TP: You’re optimistic?
RR: Long-run credibility has held steady: people continue to say that in five years’ time inflation is going to be 2 per cent. That is a crucial reason why I’m optimistic that inflation is going to come down, because even after all these shocks, once you fix policy and communication, that provides a very strong anchor.
The above transcript has been edited for brevity and clarity