Central Banks Get a Breather But Can’t Afford to Rest

Global criticism has eased up on monetary policymakers, but they shouldn’t relax their inflation-fighting efforts prematurely.

Mohamed A. El-Erian

15 Nov 2022, 07:32 AM IST

Central Banks Get a Breather But Can’t Afford to Rest

(Bloomberg Opinion) -- To say that the world’s top central banks have been under strain this year would be a big understatement given the amount of political pressure, public blame and economic condemnation thrown their way. (Indeed, because of the Federal Reserve’s consequential domestic and global impact, I have been critical of its prolonged mischaracterization of inflation and its initially underwhelming policy response to an economic threat that has already undermined economic and social well-being and that has hit the poor particularly hard.) In the last few weeks, however, global central banking has received a welcome respite in large part because of the Bank of England’s smart handling of a tough domestic situation and some easing of inflationary pressures in the US. These recent developments carry important lessons for the period ahead.

The conventional wisdom is that central banks are inherently prone to criticism because their job is, to quote William McChesney Martin, who was the longest-serving Fed chair (1951-1970), “to take away the punch bowl just as the party gets going” — that is, consider tightening financial conditions during an economic boom that could end up in tears because of runaway inflation. This was not the case, however, between 2008 and a year ago. For the vast majority of this period, central banks maintained ultra-low interest rates, repeatedly injected huge liquidity into the financial system and conditioned financial markets to expect support in the face of virtually any asset price volatility.

All this has changed in the last year with the emergence of high and persistent inflation. The initial policy fumbles — of analysis, forecasting, communication and reaction — meant that the Fed, in particular, had to pivot sharply from relative complacency to uber-tightening, delivering since the summer an unprecedented four consecutive 75-basis-points interest-rate increases in the face of an already slowing economy.

Such front-loading of rate hikes was sure to attract criticism — from politicians, market participants and, most important, households facing soaring mortgage rates and companies confronting harsher financing terms. The criticism mounted as inflation remained worrisomely high and the risk of recession rose significantly.

That criticism has eased somewhat in the last few weeks, starting with the Bank of England’s expert handling of a near meltdown in the financial system triggered by Prime Minister Liz Truss’s government going too far and too fast in cutting taxes. This was followed by a courageous stand by the bank against both fiscal dominance, whereby governments force central banks to fund their excesses, and moral hazard, whereby markets push them to subsidize excessive risk-taking. Finally, last week’s US inflation report, which was better than consensus forecasts, sparked a rally in stocks and bonds that loosened financial conditions and encouraged more investors to embrace the possibility of a “soft landing” and less Fed policy tightening.

While greatly welcomed, this respite is far from guaranteed to continue. To manage it well, central banks — and the Fed in particular — would be well advised to apply three key lessons from this year’s experience.

First, as uncomfortable as it is to face criticism on the policy journey to containing inflation, this pales in comparison to what would happen if central banks failed to deliver macroeconomic stability. Specifically, the unpleasant alternative would be an “Arthur Burns Fed” that leads the economy into a stagflation morass that would be much worse in every respect — economically, financially, institutionally, politically and socially. This is important as the Fed considers how best to tweak its messaging, including forward policy guidance, after the latest inflation report.

Second, given years of investors’ over-extension in risk-taking enabled by persistently cheap and readily available money, central banks should never underestimate the fragility of the financial system. Rather than falling back into the trap of having monetary policy co-opted by the threat of unsettling financial instability, they should be busily formulating a broad range of a risk-based policy scenarios that involve the greater deployment of preemptive measures and, if needed, reactive tools.

Finally, straight talk is particularly important at a time of such considerable domestic and global economic fluidity. It is also critical for institutions that wish, as they should, to maintain their operational autonomy in the context of strained accountability. The Bank of England has been an impressive example in this regard, setting aside politically inclined remarks for frankness and professionalism about economic developments and prospects, be it the threat of inflation surging to 13% in the absence of timely policy responses or the possibility of a recession extending into 2023.

After serving a seemingly never-ending punch of nearly free money, as well as ample and predictable liquidity replenishments, inflation has forced central banks back into their traditional role of taking away the punch bowl. This overdue pivot involves an inherently unpopular journey of policy and communication adaptation. The temptation to prematurely render this journey more comfortable in the face of recent gains would risk losing sight of the much greater prize — that of restoring the type of macro stability that is essential for enabling high, inclusive and sustainable economic well-being.