Central bankers should ponder coin tossing odds and avoid golf

In the last few weeks, all major rich-world central banks have raised interest rates. On 26 July, the US Federal Reserve raised rates for the eleventh time in its current round of increases. On 27 July, the European Central Bank (ECB) raised rates for the ninth time in a row. This was followed by the Bank of England raising rates for the fourteenth consecutive time on 2 August.

These central banks have been raising rates to control very high inflation—something these countries haven’t seen in decades. In the US, the core personal consumption expenditures (PCE) price index, stripped of food and fuel items, rose by 4.1% in the 12 months to June, much lower than the 4.6% rise in May, but still significantly higher than the Fed’s preferred 2%.

In the UK, core inflation as measured by its consumer price index (excluding energy, food, alcohol and tobacco items) rose by 6.9% in the 12 months to June 2023, down from 7.1% in May, but nonetheless the highest since March 1992. The inflation in the eurozone—which consists of countries that are a part of the EU and have adopted the euro as their currency—stood at 5.5% in June, significantly higher than the ECB’s target of 2%.

So, how did it come to this? High inflation became the order of the day in early 2021, but central banks felt that this was transitory, arguing that prices were rising due to a pandemic-induced supply shock. This was true. Nonetheless, the salaried class was flush with cash saved while working from home. Then there was the case of rich-world governments putting money directly into the hands of people. Given this, once the pandemic started to subside and economies began to reopen, people were itching to spend money.

So, yes there was a supply problem, but at the same time there was extra demand for products and services in short supply. This dynamic pushed inflation to levels that the West hadn’t seen in decades. Central banks failed to see this demand-fuelled inflation because they saw it as a problem that economics had already solved. It was seen as a problem of the 1970s and 1980s. These countries had had exceptionally low levels of inflation for a period of two to three decades.

As economist Stephen D. King writes in We Need To Talk About Inflation: “Central bankers somehow thought they were operating… in a world of greater certainty… The evidence in their favour was… sustainably low inflation.”

In order to explain the situation, King offers the analogy of a coin toss. We know that a coin which has no intrinsic bias, when tossed, has a 50% chance of showing heads and a 50% chance of showing tails. Now, this does not “rule out the possibility that five repeated throws will all land heads up.” The probability of this happening is as low as 3%, but it’s not impossible.

The trouble is that as soon as we see five heads in a row, we might start believing that the coin will throw up heads in the next toss as well, even though each coin toss is independent from another. As King writes: “To a degree, the same applies to periods of apparent economic calm. We begin to believe that nothing can go wrong. We lose sight of past upheavals.” Central bankers forgot Milton Friedman’s famous dictum that inflation is always and everywhere a monetary phenomenon. It’s caused when too much money chases too few goods and services.

This memory-lapse explains why central bankers took more than a year to start raising rates to control inflation. And when they raised rates, they resorted to gradualism, or increasing rates at a slow pace.

Ben Bernanke, a former chairperson of the US Fed, in a 2004 speech had equated gradualism to playing golf. He talked about a golfer who is leading on the final hole and expects to win the tournament. The trouble is that the golfer is playing “with an unfamiliar putter” and hence is “uncertain about how far a stroke of given force will send the ball.” In this scenario, the golfer’s best strategy is to be conservative and “strike the ball less firmly,” in order to avoid a disastrously bad shot and “approach the hole in a series of short putts.” The monetary policy equivalent of this is to raise rates gradually in order to control very-high inflation.

The trouble is that this gradualism makes an appearance only in certain situations. As King puts it: “Gradualism… if it applies at all… should apply in all circumstances… Yet there was nothing ‘gradualistic’ about the monetary policies on offer after the global financial crisis.” In the time that followed the global financial crisis of 2008, interest rates were cut to zero, and the printing of money to drive down long-term interest rates became the order of the day. The belief was that any threat to the economy only came from deflation or a scenario of falling prices.

Measures similar to those taken after the financial crisis were taken once covid broke out, but this time, instead of deflation, decadal high inflation became the order of the day. Central banks were caught napping; for them, tackling deflation was the only game in town. This assumed that the future had become more certain. However, it remains as unpredictable as ever, which is why it’s called the future.

Vivek Kaul\ is the author of ‘Bad Money’.