A wiggle of the eyebrow was all it used to take. Such was the power of the Governor of the Bank of England’s furrowed brow that not a word was needed to get the message across, according to Threadneedle Street lore.
Sir Jon Cunliffe, who sets interest rates today but also served as the Treasury’s point man at monetary policy meetings from 2002 to 2007, noted in a speech that the Bank actually “preferred to rely on the Governor’s eyebrows for both supervision and for dealing with failing banks”.
It’s not just the Bank of England who prefers to be succinct. Just over a decade ago, three words uttered by former European Central Bank president Mario Draghi marked the turnaround of the eurozone crisis.
His promise to do “whatever it takes” instantly soothed financial markets, while predecessor Jean-Claude Trichet’s level of “vigilance” would also signal if another rate rise was on the way.
How times have changed. Lockdowns and Russia’s invasion of Ukraine have pushed central banks into a world where one of the sharpest recessions in economic history was followed by a surge in inflation as the economy recovered and the war sent gas prices rocketing.
The response has been to pivot from massive stimulus and bond-buying to 11 consecutive interest rate rises in the UK and nine in the US.
But there is a growing disquiet over how central banks around the world are handling the most recent crisis, creating a sense that what was once the “only game in town” is losing its credibility.
Mohamed El-Erian, Allianz’s chief economic adviser, says the problem stems from “a degree of hubris that we’ve not seen before”.
He adds that the US Federal Reserve under Jerome Powell has made “multiple mistakes” that he believes will “impact significantly on not just the US economy, but also the global economy”.
“What I’ve been seeing of the Federal Reserve is of great concern to the well being of central banks,” he warns.
El-Erian says it started with the Fed denying that an inflation problem even existed. “Throughout 2021, the Fed absolutely insisted that inflation was transitory,” he notes. “And it ruled out any other interpretation.”
It was a similar story on this side of the Atlantic. The Bank of England’s health check of the economy in August 2021 mentioned the word “transitory” 13 times. Even when it was becoming clearer that price pressures were in the pipeline, the Bank continued to assume inflation was transitory in November, only raising interest rates once it felt comfortable that the end of the furlough scheme would not lead to a jump in unemployment.
Michael Weber, assistant professor of finance at Chicago Booth University, believes central banks are in the midst of a “potential trust crisis” thanks to a disconnect which began with a failure to recognise the pressures facing families.
“If a central bank governor comes out and tells people inflation is transitory, you don’t have to worry, it will come back down automatically, that doesn’t reflect how people are feeling,” he says.
Mr Weber adds that central bankers also made a “fundamental mistake” of focusing on what economists call “core inflation”, which strips out volatile movements in energy and food costs, just at a time when food costs are up by a fifth.
“Therefore there was already a discrepancy between what policymakers were saying and what people were perceiving which has created the beginning of a potential trust crisis in central banks,” he says.
Another former Bank of England policymaker agrees that honesty has not been the best policy. “There’s been a degree of backside-covering when they should have just admitted they got it a bit wrong,” he says.
El-Erian is also irked by how the Fed handled its communication once it recognised that inflation was here to stay.
“Powell said at the end of November that the Fed would ‘retire’ the word [transitory] from its vocabulary,” he says. “Yet it did not take policy action. So you had the ridiculous situation that in mid-March, when inflation was at 7.5pc, the Fed was still injecting liquidity into the economy.”
The Fed began its current hiking cycle that month, but El-Erian believes the damage had already been done.
Investors are now increasingly starting to bet against the Fed. For example, the central bank’s latest guidance on interest rates shows that policymakers expect the Federal Funds rate to stay at 5.1pc this year, before falling to 4.3pc next year and closer to 3pc in 2025.
But traders have been doubting the central bank’s resolve, particularly after the collapse of Silicon Valley Bank exposed some of the fragilities in the banking system.
Investors are also testing current ECB president Christine Lagarde’s claim that there is no trade-off between ensuring price stability and financial stability following Credit Suisse’s near-collapse that followed.
At one point this month, investors were betting that interest rates would be a full percentage point lower than the Fed’s prediction by the end of this year. “I’ve never seen such a big gap,” says El-Erian.
Commodities traders say the recent upward march in gold is another sign that faith in the Fed’s ability to control inflation is waning.
Disquiet on this side of the Atlantic is also growing. A survey published by the Bank of England shows trust in its ability to control inflation hit an all-time low at the end of last year. Analysts at Bank of America recently highlighted that UK mortgage rates were likely to rise in the coming weeks due to Threadneedle Street’s misreading of inflation.
Nervousness about the Fed’s credibility has been reflected in recent market gyrations. Recent research by Harvard University shows the last six press conferences held by Powell have resulted in wild swings in the benchmark S&P 500 stock index, with shares losing or gaining over $300bn (£242bn) in value.
Researchers also found that volatility was “three times higher during press conferences held by current Chair Jerome Powell than those held by his predecessors, and they tend to reverse the market’s initial reactions to the Committee statements.”
El-Erian says refusing to recognise these mistakes could end up raising questions over the effectiveness of independent central banking – which he believes is the cornerstone of good policymaking.
“These are multiple mistakes without a learning process,” he adds. “And the reason why I’m so worried is when you don’t own your mistakes and don’t learn from them, you continue to lose credibility.”
The reckoning has already begun. Australia’s finance ministry launched a review into its central bank last July after governor Philip Lowe bungled guidance about interest rates staying at record lows until 2024. The resulting reforms will make the bank more accountable and transparent, but analysts predict it will also result in the current governor’s term not being renewed.
Martin Weale, professor of economics at King’s Business School, knows a thing or two about keeping inflation in check. At the start of his tenure setting interest rates at the Bank of England in 2010, inflation was on the march, hitting a high of 5.2pc in September 2011.
In the end, this particular bout of high inflation was transitory. Weale noted in his leaving speech in 2016 that inflation during his time at the Bank had averaged exactly 2.05pc.
While he believes the last 18 months has probably resulted in “some loss of credibility” for the Bank, Weale says it hasn’t “gone out the window”. He adds that some humble pie may be in order after recent events suggest the period after the so-called “NICE” decade of “non-inflationary, consistently expansionary” output in the late 1990s after the Bank was granted independence is unlikely to be repeated.
“Central banks may have been taking too much credit for a period of unusually stable inflation,” says Weale. “There was a debate, was it because of the policy, or was it just good luck? And perhaps the architects of the policy tended to think it was all their doing.”
El-Erian is more forgiving of the Bank, noting that it was the first major central bank to raise interest rates. He says Governor Andrew Bailey’s controversial message that workers should not ask for big pay rises to avoid stoking inflation was also an admission of the tricky dilemma facing policymakers. It’s a position that’s left central bankers facing what El-Erian calls a “trilemma”.
“I think the Fed in particular is going to face three choices come the end of the summer,” he adds. “I think inflation is going to prove sticky at about 4pc to 5pc. So choice number one will be to deliver 2pc inflation and crush the economy. But that maintains the credibility of the central bank.
“Choice number two is to change the inflation target. But you can’t change it when you’ve missed it for so long. Choice number three is the ‘head fake’: to keep on promising people 2pc, but you run your policy at around 3pc to 4pc, and hope that it adjusts.”
“The sad thing is there is no reason to be here. If policymakers had started raising interest rates earlier we wouldn’t be in this world of second best where there is no good policy action.
“Economists tell you once you’re no longer in the world of first best policy, then every action you take has consequences.”
Source: https://finance.yahoo.com/news/central-banks-left-west-stuck-050000566.html