“The one lesson from the past is that central banks must focus on anchoring inflation expectations, ensuring that the mistakes of the 1970s and early 1980s are not repeated. But one key lesson from the past is that one instrument of macroeconomic policy cannot do everything”, Professor Sir Anton Muscatelli writes in this opinion piece
Many economists have been warning us that central banks must avoid the mistakes of the 1970s. They rightly point out that policymakers like the US Federal Reserve underestimated the threat of inflation then, following the 1973-74 and 1979-80 oil shocks, which required painful disinflation policies to bring inflation under control. These disinflation policies created deep recessions with much higher unemployment in the early 1980s.
Indeed, since the 1970s many countries have delegated monetary policy from Treasury ministers to independent central banks, to avoid political short-termism in the setting of interest rates. The Bank of England became independent in 1997, the Reserve Bank of New Zealand in 1990. In Europe, the advent of European Monetary Union created a European Central Bank (ECB) with independence from the political institutions of the EU and its member countries.
It’s absolutely right to point out that we should learn from past mistakes in not taking inflationary threats seriously, allowing inflation expectations to become embedded, and setting in motion a wage-price spiral which would then require central banks to raise, both nominal and real interest rates even higher than would be the case if we acted in a timely fashion. Indeed, many see the caution of some central banks, particularly the ECB, as counterproductive in this regard.
However, it is also important to emphasise some important differences from the 1970s. Differences which make the current policy dilemma more difficult for central banks and governments.
First, the initial inflation shock this time is broader-based than in the 1970s. Russia’s invasion of Ukraine has not only caused a shock to oil prices, but also (primarily in Europe) a gas-price shock. The supply of many materials has been seriously impacted by the war in Ukraine, from metals like iron and steel and nickel, to construction materials and petrochemical products, to key intermediate products like neon and palladium used in electronics manufacture. The increase in food prices as a result of the war are also causing a real humanitarian crisis in many parts of the Global South, with low-income countries in the Middle East and Africa highly dependent on food imports from Ukraine and Russia.
One of main lessons of the Covid crisis and the current war is that global production chains are much more complex than in the 1970s. Globalisation makes it more difficult to understand how the shock from the war in Ukraine, or indeed the ongoing Covid emergency in China with repeated lockdowns in key manufacturing centres like Shanghai, will hit the global economy to not only raise prices but also reduce output, causing stagflation. The uncertainty on the nature and persistence of the shock is more marked, making decisions more complex for policymakers.
Second, in Europe, the ECB faces particular difficulty in managing the unwinding of its asset-purchase programmes (quantitative easing) as it tightens monetary policy to fight inflation. As it raises interest rates it needs to ensure that it avoids sudden increases in sovereign risk premia which could open up between more indebted countries like Italy and Spain, and less indebted ones like Germany. Unlike the monetary authorities in the 1970s the ECB faces a much more complex situation as it manages monetary policy across different economies. Rising sovereign risk spreads could disturb the smooth functioning of European financial markets. Continuing selective asset purchases such as those used during the pandemic emergency purchase programme (PEPP) might be helpful here.
Finally, an important lesson from the 1970s is that monetary policy cannot do everything. One factor which might make the current inflationary shock easier to manage this time is that in many countries real wages are probably more flexible than in the 1970s. That is helpful in terms of managing inflation but creates deeper inequalities. Poorer countries are already suffering from food price hikes, and we should ensure that agricultural exports continue to flow to lower-income economies. But even within higher-income economies, the effects on inequality will be very significant as poorer households’ consumption spending is more concentrated on necessities like food and energy. The massive energy price increases in Europe in particular will be persistent and significant. In the UK, with inflation well ahead of wage increases and net taxes rising in April, the independent Office for Budget Responsibility has estimated that real living standards will fall by 2.2 per cent in 2022-23. This will be the largest financial year fall in recent history. This is one of the reasons why the focus of fiscal policy should be on targeting temporary and means-tested support to the most vulnerable households. As has been argued by many, including the OECD, these measures could be financed by considering windfall taxes on energy company profits.
The one lesson from the past is that central banks must focus on anchoring inflation expectations, ensuring that the mistakes of the 1970s and early 1980s are not repeated. But one key lesson from the past is that one instrument of macroeconomic policy cannot do everything. Fiscal instruments have to be deployed to protect the most vulnerable, and as in all emergency situations all aspects of macroeconomic policy have to be closely coordinated.
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