Are Central Banks Effective in Fighting Inflation?

From August 15,1971 onwards, foreign exchange markets came in existence and each country was responsible for its money supply and its exchange rate.

Are Central Banks Effective in Fighting Inflation?
From August 15,1971 onwards, foreign exchange markets came in existence and each country was responsible for its money supply and its exchange rate.

 By Lord Meghnad Desai

Ever since the last cycle of Stagflation inaugurated by the quadrupling of the Oil price by OPEC, several ‘certainties’ have ruled the doctrine on fighting inflation. Foremost among them is the autonomy of the Central Bank (from the elected government). Then we had the abandonment of the Keynesian orthodoxy and the adoption of the monetarist solution. This required that the Central Bank have the powers to raise interest rates as the best device for lowering the rate of inflation. Central Banks began to adopt targets with a pledge to bring inflation below the target level and keep it there. The Fiscal authorities were supposed to cooperate by declaring a Medium-Term Fiscal Path.

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So far, a standard, almost universally adopted approach. Few economists are aware that under the Gold Standard, no country had monetary sovereignty. The Bank of England had fixed the price of gold at £3.17shillings and 9 pence. [ It is easier nowadays to see it in terms of US dollars. Gold was $18 an ounce given the exchange rate between dollar and pound sterling. When in 1971, Nixon reneged on the convertibility of the dollar into gold [ as promised at Bretton Woods,] the price of gold had already moved to $35 an ounce, nearly 100% depreciation since the US became de facto in charge of Gold Standard after 1918. The depreciation was declared by Roosevelt not by the Federal Reserve.

From August 15, 1971 onwards, foreign exchange markets came in existence and each country was responsible for its money supply and its exchange rate. We have now lived in this environment for fifty plus years.

The well-known approach to reducing inflation is to raise the Bank Rate (or whatever name is given to it.) The theory is quite simple. Inflation is a monetary phenomenon, if not in cause at least in its cure. For some reason the Aggregate Demand (AD) Curve has moved to the Right due to inappropriate monetary expansion (caused by loose fiscal policy, high Debt GDP ratio etc.) Raising the bank rate will move the AD curve to the left. If the Aggregate Supply (AS) Curve is stable, the price level will fall.

During the 1970s, oil prices were quadrupled. This should have meant that the AS Curve had moved to the left exogenously. Even so, the monetarist doctrine prevailed, if not immediately after roughly ten years of trying various ‘Keynesian’ nostrums- incomes policies etc. By the end of the Seventies, in US and UK (and West Germany) monetarism took command. Bank Rate was raised, money supply was sought to be controlled and after unemployment reaching highest ever levels since 1939 inflation was brought under control, Monetarists claimed a vindication of their doctrine.

Central Bankers were the new heroes. Governments learnt the lessons to behave themselves. Stagflation lasted much of the two decades from 1973 to 1987. The cure was not so much due to Central Banks but as I have argued because a lot of manufacturing was relocated to Asia by American and European manufacturers where the cheap labour available reduced the price of manufacture, a big item in the Price levels of developed countries. (Hubris (2015)) Anyway, the prize was claimed by Central Bankers. Alan Greenspan ruled the world until 2008 shattered his reputation for omniscience.

All the above is familiar. But now we are here again. There is another upsurge in energy prices. Monetarists blame it on the loose monetary conditions which were pursued during the Pandemic which came just a few years after Quantitative Easing was used by Central Banks. Could it be the right policy? Let me suggest that both the 1970s and the 2020s episodes are due to a shift in the Aggregate Supply Curve not the Aggregate Demand Curve.

The consequence of this is that trying to move the AD Curve to the left by raising interest rate increases the cost of fighting inflation (deepening the stagnation) but does not reduce inflation which is supply determined. Central Banks have no power to move Aggregate Supply Curves. The Aggregate Demand Curve punishes consumer households by raising the cost of financing consumption – causing unemployment, wage cuts, persistent high exogenous energy prices etc. The misery is compounded by the simple fact that even as the Central Banks try to move the AD Curve to the left, there is an irreducible lower level below which the AD curve will not go. In effect, the AD Curve will be highly inelastic at lower levels of demand no matter how high the price goes.

[The Idea that consumption has a lower bound is common sense but if you want a fancy handle for the argument think of the Stone Geary Utility Function (or the equivalent Linear Expenditure System to see this]

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In summary, as the Central Banks have no control over Energy prices, reducing money supply by raising interest rates will inflict a long stagflation period on the economy. In the previous episode 1973-1990 it took the move to Asia by manufacturers which rescued the Central Banks. This time the scope for reducing the energy costs borne by households is not likely to be reduced any time soon. Investments in home insulation, development of alternative energy sources (while not worsening climate change / no fracking please) cost money. But the lesson will be budget cuts. With or without tax cuts (as promised by Liz Truss), the fiscal policy solution will be ruled out by the current approach.

So, look forward to two decades of Stagflation.

(The author is chairman at Meghnad Desai Academy of Economics and Professor Emeritus, London School of Economics. Views expressed are personal.)

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